How ready are index managers for MPF?

Hong Kong's Legislative Council is now considering an amendment to the Mandatory Provident Fund Schemes Bill that, among other things, will lift some restrictions on how MPF members can invest their funds. The most significant change is to allow MPF constituent funds to invest up to 100% into an exchange-traded fund (ETF) or other index-tracking fund product. This means global ETF players such as State Street Global Advisors (SSGA) and Barclays Global Investors (BGI) are thinking about how to enter the already crowded MPF field.

At this stage, index fund providers have no immediate intention of wading into the MPF market. They must still wait for Legco to pass the amendment. Although the content of the amendment is not controversial, at least not that relating to allowing MPF investors access to ETFs, the amendment is also not at the top of Legco's priority list. With summer recess looming, it is likely that it will not be passed until the end of the year. And even then, SSGA, BGI and any other ETF providers will have to assess the market.

ETFs are hybrids between stocks and mutual funds that trade on an exchange, and their NAV mirrors that of the underlying stock index. Contributions and redemptions for ETFs are in kind (ie, units are built with complete baskets of the index stocks) not in cash. Because of their essentially passive nature, ETFs are cheaper than mutual funds and carry no risk relative to index benchmarks, and are often used as core holdings for institutions as well as individuals.

Despite these attractive characteristics, ETFs got left behind when Hong Kong bureaucrats drafted MPF legislation. The Tracker Fund, Asia's best-known and most successful ETF, which is managed by SSGA, was only founded in late 1998 as a means for the Hong Kong government to dispose of its stock market holdings following massive intervention to ward off currency speculators. By that time the MPF legislation - which is a tangled legal maze, reflecting the many political interests behind its passage - was already nearing completion.

The Tracker Fund breaches the requirement that any MPF constituent fund offered by a master trustee approved by the Mandatory Provident Fund Schemes Authority (MPFA) can hold no more than 10% in any one security. The Tracker Fund, like many ETFs, follows an index (in this case the Hang Seng) with a handful of stocks that comprise more than 10% of its market capitalization.

After MPF launched in January 2001, lobbying by the index industry moved ETFs into a halfway house. MPF rules allow constituent funds to invest up to 10% in 'other' investments such as mutual funds, as opposed to securities. ETFs were allowed to be considered an 'other' investment, but this was not a meaningful gain for index players. Their lobbying efforts have now paid off in this new amendment before Legco, which allows constituent funds to invest up to 100% in ETFs approved by the MPFA.

So will SSGA and BGI leap into the fray once the law is changed, and will MPF contributors get a cheap indexing option for their long-term investments?

Officials at SSGA and BGI say not right away. It could be two years or so before they are ready.

Winnie Pun, director of product engineering at SSGA, says the firm will have a choice once the amendment is passed.

One is to get current master trust schemes to offer an ETF - the Tracker Fund is of course the natural pick - to clients on a third-party basis. But Pun says most current master trust schemes are not multi-manager. Furthermore there would have to be a lot of wrangling about legal charges, fees and so on.

Adds Joseph Ho, BGI's regional director for North Asia, "We could easily manufacture a product for a third-party manager, but there are still a lot of regulatory issues that need to be clarified." He says the day an MPF constituent funds invests 100% in a BGI iShares ETF (which track various MSCI country funds) is far away.

Pun says the other choice is for SSGA to launch its own master trust scheme. But this brings more hurdles. An MPF master trust provider must offer a range of products for different risk appetites, including a guaranteed or capital-preservation fund, balanced funds and aggressive funds. SSGA would have to manufacture these or outsource to other fund managers.

Then there is the broader issue of MPF business profitability. Trust and legal fees are high, and for the next few years, at least, assets under management are tiny. Moreover, the field is dominated by five players with over 80% of the market, with another 15-odd players battling over crumbs. "We would want to do something meaningful and not be one of those fighting for the scraps," Pun says.

Indeed, the MPF industry is likely to consolidate over the next year or so, and Pun says SSGA will not launch an MPF business of any stripe until that process settles. SSGA is considering possible acquisitions of existing master trust schemes, but for now none are floating distressed-level prices. "We wouldn't want to pay for all of their investments," Pun says.

Nonetheless, at some point SSGA intends to crack the MPF market. Over time its assets will become substantial. Moreover SSGA thinks that multi-manager funds will become more common, as in the US 401(k) market. And the Tracker Fund meets MPFA requirements that funds have at least a 30% exposure to Hong Kong dollar-denominated assets. With the right business plan, the Tracker Fund is an obvious attraction for MPF contributors.

BGI lacks that no-brainer product. But it too sees a potential business in MPF, says Ho. The firm could either create a Hong Kong-based index product to compete with Tracker, or emphasize offering MPF investors its range of international ETFs. "The US stock exchanges are recognized stock exchanges in Hong Kong and we have 77 products there," he says.

In fact, some MPF fund managers are already investing in iShares as part of the currently allowed 10% allocation to 'other' investments. Ho says iShares have been popular for MPF players investing in international markets such as the US because they are an efficient way to cover a market with small allocations. But no ETF provider will be prepared to offer something more substantial to the MPF market until the details and technicalities of the new amendment are understood, he says.