Key lessons from the first Inside ETFs Asia

Inside ETFs Asia's first edition in Hong Kong was a huge success, bringing together over 300 financial professionals with world-leading ETF and investment experts to debate the most important issues facing investors in today´s challenging markets. Debate was invigorating and we have captured a summary of key issues discussed covering a diverse range of interesting topics.

Unsurprisingly the new stock connect channel was discussed with panelists in agreement that it is a superb innovation for China as it allows international investors a way to transact China A Shares through international banks and brokers.  The connect channel is being modified to allow easier conversion to CNH (offshore Chinese currency) though the need to pre-fund was seen a hindrance. 

Tobias Bland explained that Chinese companies listed on both the local A Share market and the Hong Kong H Share market have historically had two separate investor bases; since international investors were only able to trade H Shares, unless they had RQFII/QFII.  With the addition of Stock Connect there is an expectation that the pricing differential between A and H Shares will narrow over time. There is alpha to be extracted by replacing A Shares with H Shares when they are expensive; and vice versa.

 “Once implemented, ETF Connect could help given mainland investors a new means to diversify into international and thematic strategies through HK listed ETFs,” said Bland. 

Concerns or perceived concerns with ETFs were also high on the agenda with several attendees raising the concern that ETFs are said to offer a ‘false sense of liquidity’ in inherently illiquid asset classes, with high yield bonds being the most notable example. He explains to clients that ETFs have two layers of liquidity; primary market (underlying basket of securities) and secondary market (ETF shares traded on exchange).

For fixed income ETFs that cover the high yield market, investors should recognize that a mature ETF will likely provide better liquidity in times of market stress than the underlying, due to its extra layer of secondary liquidity.  The secondary market liquidity will shield investors from the high yield bond market’s primary market liquidity until is used up. Only after the secondary market liquidity is used up, are investors left with the high yield bond market’s primary liquidity. Investors should weigh the benefits received from ETFs secondary market liquidity versus the risk involved in investing in high yield bonds; as similar risks are found in direct investments and ETFs. 

Inside ETF Asia attendees wanted to understand what are the risks associated with synthetic ETFs. Our experts explained that the most obvious risk associated with synthetic ETFs is counterparty risk.  However, counterparty risk can be found in physical ETFs as well as a good portion of physical ETFs lend the stocks in their portfolios. The Hong Kong Synthetic Structure is unique since as it requires ETFs to hold physical blue chip securities that are equivalent to the NAV of the fund; resulting in mitigated counterparty risk. 

“ETFs are only as good as the markets or strategies they replicate, so investors should take time to understand the strategy before investing. Investors should not invest blindly into an ETF without understanding the risk of structure or underlying market,” said Bland.

No discussion about ETFs would be complete without smart beta and with more active managers entering the ETF space, attendees wanted to know when will the lines blur between smart beta and active coat-tail ETFs.

Bland went further to explain that “…lines are already blurring between active and smart beta, as a lot of active managers tend to be closet indexers, suggesting that anyone that is focused on running an active strategy of more than 100 names will be taken over by a smart beta fund. The more concentrated an active manager’s strategy is the more likely that manager will deviate from an index and be able to stand out from the market; for better or for worse.”

From a product standpoint Asia is developing similarly to other markets; first with the role out of country index funds, then with the development of smart beta, then L&I and active.  EIP believes Asian investors will prefer thematic and smart beta strategies to passive strategies, given their higher tolerance for risk and volatility. 

Attendees wanted to know if MIFID will make ETFs the investment vehicle of choice for Asia investors and our panelists felt that MIFID will increase the amount of assets managed in Asia dramatically. Going forward only clients in the European Union (EX UK) will be regulated by MIFID. Asian financial institutions will have the ability to buy global asset managers and their vendors at cheap prices in the coming years and rebase them to Asia; similar to the car industry. 

One of the key issues raised was how to encourage more investors to invest in ETFs in Asia to which Tobias Bland had a range of suggestions:

• To set an example the Hong Kong Government needs to buy Hong Kong listed ETFs instead of US listed ETF.
• Insurance companies, Asset Managers, and wealth advisors need to recognize that ETF costs can provide great savings, instead of just focusing on an ETFs volume. Approximately 30% of ETF volume in the US for Asian indices is from Asian investors; something we think is inefficient.  End investors suffer from an increased tax rate on dividends and overnight execution risk, since Asian markets are closed.
• By fostering regulatory change in the market that bans retrocession fees.
• Introducing a sensible market making incentive scheme.
• Reducing the cost of bringing an ETF to the market and simplifying the delisting process.
• Creating an even regulatory playing field for active funds and ETFs.  Currently Hong Kong and Singapore, fall drastically behind US and European markets on disclosure of fees and retrocessions. ETFs can be promoted in a fair and equivalent manner as mutual funds, once the regulation in Asia is up to standards of other developed markets.