ETF shakeout in Asia would not be bad: EY

An expected shakeout among exchange-traded fund providers in Asia would not necessarily be bad for the industry as it points to a maturing market, says Ernst & Young.

Moves by HSBC and Lyxor to delist smaller ETFs is forecast to catch on with the International Organisation of Securities Commissions (Iosco) understood to be talking to regulators in Hong Kong and Singapore about potential delisting of smaller ETFs.*

Matt Forstenhausler, New York-based partner at EY, sees ETF closures as inevitable in Asia as the industry develops. He points to the US market, where 95 ETFs delisted last year and 42 in the first six months of 2013. Mostly these were small providers delisting ETFs with low volumes, poor volume and high expenses.

“It’s like throwing spaghetti on the wall. Some stick and some fall off,” Forstenhausler told AsianInvestor on a recent trip to Hong Kong. “We see the closing of ETFs as a healthy by-product of the market. Because [ETF providers] want a first-to-market advantage, you see lots of launches and a lot of people coming up with new product and seeing if it works. If it does, great. If it doesn’t, they’ll close the ETF.”

Smaller ETFs have higher expense ratios, wider bid-ask spreads and potentially higher tracking errors. They can also be burdensome for market-makers that have pledged to provide liquidity, especially given there is little day-to-day volume.

While the delisting of small ETFs may gather pace, Forstenhausler notes that the industry in Asia is in a growth cycle, with ETF launches contributing to a compound annual growth rate of 37% over the last 10 years.

Despite the prospect of this tapering, EY is still forecasting 20-30% growth in the next three to five years in Asia, against 15% in the US and 15-20% in Europe, finds EY’s recent study A New Era of Growth and Innovation.

But Asia’s ETF markets are fragmented. Local players dominate in Korea and Japan, while Hong Kong remains the jurisdiction of choice for foreign and regional players looking to launch new product.

EY expects new players in Asia to be established firms from North America, Europe and China, which will seek to launch funds via a Hong Kong unit trust scheme.

There will be some first-timers – EY anticipates the Philippines will introduce its first ETF next year, with providers in Vietnam and Indonesia to follow suit.

But unlike the US and Europe, where the top three ETF providers represent 81% and 71% of their markets, respectively, Asia’s top three providers – Nomura, Nikko Asset Management and Daiwa Securities Group – only account for 41%.

“Asia is up for grabs for both new and existing [ETF providers],” argues Lisa Kealy, partner within EY’s financial services assurance group based in Dublin.

That said, size matters and that won’t change as large institutional investors are required to invest in ETF providers with a certain AUM. “Smaller funds struggle for inflows and the single biggest reason why fund launches fail is lack of inflows,” Kealy notes.

For example, Asian asset owners allocated a significant portion to established ETF players overseas – two-thirds of Asian institutional ETF inflows go into developed firms in the US and Europe annually, by EY estimates. “Asian investors are forced to invest outside Asia in order to reach their minimum size requirements,” says Kealy.

But this will change as Asia’s ETF market develops and becomes more competitive, she adds. According to EY’s numbers, 91% of Asia Pacific ETFs invest in equities, with 48% focused on Japan and 28% on China.

Improving distribution will be crucial to the next phase of growth for ETFs globally, stresses EY. Institutional investors are seen as the most important users of ETFs. Educating institutions in emerging markets is seen as key, with promoters hoping that product innovation will spark demand and help them to capture a greater share of pension fund assets.

Capturing retail business will remain a challenge, however, particularly for ETF providers in Asia. Few will replicate the success of the US, where promoters use a range of channels, including proprietary sales teams and independent brokers.

For the moment, ETFs are struggling to gain traction with platforms and supermarkets set up for mutual funds, the research found. “We feel that issuers need to engage much more proactively with platforms to explain the benefits of ETFs to retail investors,” says EY.

*An extended feature on consolidation in the ETF industry appeared in the November issue of AsianInvestor magazine.