Building an ETF strategy in Asia: is it worth it?
ETFs that focus on a niche strategy or market tend to do better in Asia
Much has been made about the rapid growth of the exchange-traded fund (ETF) market and the vast opportunities for profit. Assets held in ETFs globally reached US$5.1 trillion, expanding yearly by an average 18-20% over the past 10 years. The US accounts for 70% of the total (US$3.6 trillion), while the European ETF market stands at US$800 billion in assets. Asia represents a much smaller portion of the market. Overall growth has been robust in the region, thanks to Japan that represents 40% of the region’s US$400 billion ETF assets. Elsewhere in Asia, expansion has been slow. The growth of Hong Kong’s US$40 billion ETF market, for example, has been stagnant since 2014. In the last two years, it has pulled out about 50 ETF products from the market.
“While a lot of people are seeing the megatrend of a lot of active funds moving to the passive side, it is not necessarily the case in individual markets. In Asia, a lot of ETF markets have not grown as fast as many people in the industry expected,” says Vincent Chen, head of Index and Quantitative Investments, ICBC Credit Suisse Asset Management.
Building a strategy
When it comes to building an ETF strategy for Asia, there are a number of challenges that an asset manager has to address. The major challenges include distribution, product suitability, and investor education.
Perhaps the biggest challenge to the growth of ETFs in Asia is product distribution. At present, almost all ETFs are sold through bank distribution channels, which means the success of an ETF in terms of sales depends on how much shelf-space and exposure it gets on the marketing channels of the big distributor banks.
In particular, its success depends on how much effort a bank’s salesperson or relationship manager will put into pushing the product to clients.
This is where retrocession fees, commissions or rebates come in to incentivize bank distributors. Retrocession fees can be as high as 50-60% of total fees and have been a traditional part of the fund management distribution networks of Hong Kong and Singapore for a long time.
Unlike mutual funds, ETFs are low-cost investment vehicles, hence, there is little in terms of fees to work with.
“Hong Kong and Singapore are the last two markets that still promote retrocession fees. In Hong Kong there’s about US$2.5 billion paid to intermediaries to sell mutual funds. So we pay these distributors to sit in the middle and get a percentage of the management fee of the fund and therefore the people promoting those funds are not incentivized to sell ETFs,” says Tobias Bland, the chief executive officer of EIP.
Bland cited Australia as an ETF market that is experiencing massive growth after retrocession fees were removed. “They (Australia) stopped retrocession fees about four years ago. Since then everybody wants to have a low-cost, efficient product because the distributors and clients now have the same motivation. They want to be able to find the investment that is best for their clients without paying the highest fee.”
The lack of proper incentives on the part of distributors to push ETFs would partly explain why the growth of the product has been slow in certain markets like Hong Kong and Singapore.
In terms of investor profile, it also explains why the ETF market in Asia is still dominated by institutional investors that account for 80% of the market. This is unlike in the US and Europe where retail investors comprise a substantial portion of the market.
Investor education is also a key challenge for building an ETF strategy, especially when it comes to retail investors.
The situation is compounded by the fact that the definition of certain concepts can differ from one fund manager to another. For example, the concept of “absolute return” is easier for retail investors to understand while “benchmark return” is a harder concept because different fund managers use different benchmarks. Benchmark returns are particularly relevant for ETF investors because an ETF tracks a benchmark and that is where the investor expect to get the return.
Another challenge when it comes to investor education is how to overcome the “gambler’s mindset” of expecting quick and huge returns from ETFs.
“Most of the retail investors are looking for a 50% return in a year and most ETFs can not do that,” says Jacky Choy, director of ETF research for Morningstar.
Experts agree that investor education should push retail consumers to use ETFs as an asset allocation strategy for their portfolios rather than for speculation.
“It may sound boring but client education is the most important thing. Investors have to know who is the seller of the ETF and what an ETF house focuses on. Do they provide sector ETFs, high-tech ETFs, or China new economy ETFs,” says Chen Ding, CEO at CSOP Asset Management.
Retail investors have to learn how and when to use the more sophisticated products such as the leverage and inverse (L&I) ETFs, which are highly-speculative by nature. L&I ETFs have been successful in Hong Kong, for example, because of the relatively mature derivatives markets. In Taiwan and South Korea L&I ETFs also account for a huge portion of the turnover on a daily basis
In terms of product suitability, a distinction has to be made between the preferences of institutional investors and retail investors. Asian institutional investors who want to trade in US ETFs or European ETFs prefer to do it in New York or London where there are better liquidity and larger volumes for such products. In certain ETF markets, home bias investing exists.
“If you look at the Hong Kong market, most of the assets under management are concentrated on domestic equities or China equities. An index like the S&P500 listed locally doesn’t get too many assets here,” says Chen of ICBC Credit Suisse.
Chan Kum Kong, head of research and products, equities and fixed income of the Singapore Exchange suggests that ETFs that focus on a niche strategy or market tend to do better in Asia.
“What works? It’s got to have a niche flavour. For your plain vanilla, geographical, high benchmark ETF – in Asia there is very little point because the primary markets are mostly the US and Europe. Anybody who wants to trade these ETFs will typically go there,” Chan says.
“For the asset managers here, it’s got to be within the context of the market. What’s the strength of that particular market, you’ve got to cater to that, and have an ETF wrapped around that area,” he adds.
Despite these challenges the potential growth for ETFs in the region is still strong.
“But there is this overarching principle that, over time, as pension pots grow in China and Hong Kong, there is going to be a need for this liquidity debate – a top-down asset allocation in an educated way for generations to come,” says Bland.