Traditional funds face active ETF challenge

Actively managed exchange-traded funds are not yet widely available across Asia, but when they become so, traditional active fund managers may have to rethink their offerings, say industry experts.

Such products have great potential, assuming they can overcome certain challenges, argued participants on a roundtable* hosted this month by AsianInvestor.

Active ETFs have taken off in South Korea, with inverse and leveraged funds, for instance, seeing impressive trading volumes. They are also permitted in Australia and this year got the green light in Japan, but cannot yet be listed in Hong Kong or Singapore.

“Active ETFs will become a very important part of the landscape in five to 10 years,” says Joseph Ho, Asia-Pacific head of ETFs at Credit Suisse. “As exchange trading becomes the preferred way of distributing financial products [as opposed to the current third-party distribution model], active ETFs can be as common as passively managed ones.”

That said, there are technical and regulatory issues to be worked out, Ho notes, such as over daily disclosure of holdings raising the risk of active ETFs being front-run. 

Still, he cites Pimco’s actively managed bond ETF – which has attracted $2 billion in AUM – as an example of the potential for this market.

“It’s a bond fund, so it doesn’t face the same issues of an actively managed equity ETF such as front-running,” says Ho. “You can’t front-run it even if you know the holdings, because bonds are mostly traded OTC, and you would not have the resources and financial strength to compete with Pimco.”

New launches have certainly helped to boost other markets. “Look at Korea,” notes Ho. “Once leveraged and inverse ETFs were introduced, trading jumped to 20-30% of overall stock-market turnover.

“While that is only one example, the reality is the Lehman Brothers minibond incident has left a bad memory with regulators in the region, so we haven’t seen much product innovation in the past few years.”

Hedge fund managers would like to see more active ETFs. “In the past, many active funds started using ETFs and we also started using them in some way,” says Chris Choy, head of investment at Hong Kong-based Quam Asset Management. “The same can happen with active ETFs.”

Traditional managers are less convinced. “I don’t think the world will evolve into 100% ETFs,” says Andrew Tan, CIO at Harvest Global Investments in Hong Kong. “If it did, fundamental and corporate results would no longer matter. Markets would be extremely inefficient. Any large index stock would still go up regardless of the fundamentals.”

Ultimately, he argues, it can’t happen because valuations do matter. Tan admits ETFs have been “cannibalising” active fund managers’ business, but believes the market will reach an equilibrium between the two.

Nonetheless, says Stephen Hull, Asia ex-Japan head of client solutions at BlackRock in Hong Kong, “the flows into ETFs and index funds in recent years have forced many active managers to refine their value proposition. It’s made the industry more competitive in that way.”

One point is that institutional investors in Asia have shown interest in concepts such as the replication of sources of risk premium or sources of alpha, says Mark Valadao, Hong Kong-based executive director at index provider MSCI.

“There are certain characteristics in equity markets that active managers use to gain outperformance,” he adds. “And they could be systematic sources like momentum, value or low volatility. These are fundamental characteristics that can be replicated through indexation.”

Another area of demand has been for customisation; cutting and slicing particular segments of the market and building an index around that, notes Valadao.

Hull, whose team runs portfolios on a discretionary basis for institutions, agrees that active approaches that can be replicated through beta instruments represent a growing area of interest.

Jianbo Wang, Asia head of ETF trading at Deutsche Bank in Hong Kong, makes a similar point. “In 10 years, standardised alpha risk factors will become something passive managers manage,” he says. “Then the active manager will need to move up the value chain to offer other things.”

*An extended feature based on the discussion will appear in the forthcoming (November) issue of AsianInvestor magazine.