Korean fund managers launch ETF wave

Four South Korean fund managers are expected to simultaneously launch the country's first exchange-traded funds (ETFs) some time in September. This will provide both retail and institutional investors with a cheap, flexible way to invest in the Kospi stock market index and provide a useful hedging tool. It may also give foreign investors a legal means to bypass ownership restrictions and help smaller foreign investors gain a credible Korean exposure.

Exchange-traded funds are a basket of shares that trade as a single security, giving investors the benefit of a mutual fund and the ease of trading a stock. Because the market makers (known in Asia as authorized participants) create and redeem units of ETFs with the fund manager in kind as baskets of securities, not cash, ETFs are also a convenient way to short a market without weakening it û because to first short an ETF unit, that unit must be created. So for a variety of reasons, ETF assets in the United States have soared even as mutual funds have suffered redemptions.

In Asia, the ETF scene was long dominated by the Hong Kong Tracker Fund (TraHK), managed by State Street Global Advisors, which was designed to help the government dispose of its massive equity holdings following market intervention in August, 1998. Thanks to the government's explicit support and discounting, the Tracker was a success, raising over $4 billion upon its initial public offering. Although poor market conditions have seen assets under management fade to roughly $3.3 billion, the TraHK remains the region's ETF standout.

In a way this made the progress of ETFs in Asia harder, because every government or manager seemed to look to TraHK as a benchmark. In reality, just as there can be only one SPDR or QQQ in America (the ETFs for the S&P 500 and the Nasdaq 100) there can be only one Tracker. Other ETFs in the region have been modest, their growth overlooked because of their relatively small size.

Moreover, regional regulators did not understand ETFs and were wary of their role as shorting tools. The only ETF exposure available to markets such as Taiwan and Korea remained iShare ETFs, a product of Barclays Global Investors (BGI) based on MSCI country indices, which have been available to Hong Kong investors since last year.

Indeed, Bae Jae-kyu, CIO for index and alternative investments at Samsung Investment Trust Management Company (Samsung ITMC), says his firm began lobbying authorities to let it launch an ETF three years ago, after Bae and colleagues discovered the product while attending a conference in Hong Kong. It took nearly two years to convince the regulators that ETFs were a positive idea.

What really turned the corner, however, was the launch of ETFs in Japan in March, 2001, which Japanese authorities promoted to boost the equities market.

The Korean regulators took another page from the Japanese by licensing multiple fund managers to launch ETFs tracking the same index. Whereas the US, Hong Kong and other jurisdictions allow only one manager for each ETF product, Japan allowed four players to launch ETFs based on the Topix and three covering the Nikkei 225.

So next month, once the date is finalized, both Samsung ITMC and LG ITMC will launch ETFs based on the Kospi 200, while Hantu ITMC (also known as Korea ITMC) and Cheil ITMC will launch products tracking the Kospi 50.

There is little to distinguish between the Samsung and LG offerings, but Bae says it would have been impossible to get exchange-traded funds at all without a collective lobbying effort from the industry, and ITMCs would only agree to pressure regulators if they felt they weren't merely benefiting a competitor.

Both Samsung and LG had help from outsiders. BGI is advising Samsung while SSGA is advising LG, with the foreign partners splitting the management fee based on assets under management.

At this point it seems as though the foreigners are being limited to a backseat role. Vincent Duhamel, regional CEO at SSGA in Hong Kong, says, ôThe administration system was developed locally. We were asked to advise the administrator and LG to ensure their systems would be able to process ETFs.ö

Hantu and Cheil are not using foreign partners, according to market participants, although those firms could not be contacted directly by press time to confirm.

Both Samsung and LG are using domestic fund administrator A Brain for trust duties.

Bae frets that sagging market conditions and a frail US economy could get ETFs off to a bad start. But he notes that Koreans are experienced index investors û Samsung ITMC alone manages W2 trillion ($1.7 billion) in passive money û and that the Kospi 200 enjoys a liquid, highly traded futures market, essential to successfully keeping ETF net asset values in line with the constituent stocks'.

Joseph Ho, regional director for North Asia at BGI in Hong Kong, points out that ETFs faced even worse market conditions in Japan, but providers such as Nomura Securities have used their distribution power to amass respectable assets under management. He believes a player such as Samsung can do the same in Korea.

The major difference between Samsung and LG's offering may be that Samsung ITMC is using three foreign authorized participants, CSFB, Deutsche Bank and Salomon Smith Barney, as well as three local securities houses. LG has more authorized participants but they are all local.

Ho believes this will give Samsung ITMC an edge, as foreigners with global expertise trading ETFs can add confidence. Moreover they are a conduit to foreign investors. Smaller foreign fund managers may want to buy ETFs instead of putting all their allocation into just a handful of stocks, in order to buy the market.

Bae adds ETFs offer fewer restrictions on foreigners' exposure to domestic companies, with ETFs allowed to hold up to 30% of its portfolio in one company. Foreign-invested mutual funds investing in Korea typically cannot allocate more than 10% to a single stock. This relaxation for ETFs was granted to ensure the fund faithfully tracked the index. It is also why Samsung and LG are licensed to cover the Kospi 200, not the MSCI Korea country index, which has a smaller pool of constituents in which big names like Samsung Electronics sometimes consist of 40%.

The drawback to the Kospi 200 is that the bottom half is full of small, illiquid stocks. Therefore both Samsung and LG will be forced to optimize their portfolios û ie deviate from the index to the point that the ETF remains investible. How well they manage this optimization process will help determine the success of ETFs in Korea.