Analyzing ETF investments and clarifying misconceptions for Asian investors

From Archive 21 April 2010

By Marco Montanari

Since their debut in the nineties, Exchange Traded Funds (ETFs) have become a popular tool for investors seeking cheap, liquid, flexible exposure to equities and other asset classes. By the end of 2009, assets managed by ETFs worldwide reached over one trillion US dollars^*. While the US and European ETF markets account for more than 90% of ETF assets globally, it is the potential for ETFs to take off in Asia which has really captured people’s attention.

Like many others investors around the world, investors in Asia, including pension funds, sovereign wealth funds and insurance companies, are becoming increasingly aware of the benefits of ETFs. In 2008, while equity markets around the world suffered large declines, the ETF market in Europe actually grew by 14% as investors sought shelter in beta investments^*. Growing interest in beta products, increasing demand for efficient access to a diverse range of markets, and dynamic economic growth are all factors which suggest that the Asia ETF market is on the verge of significant growth.

As the market expands and Asian investors are presented with more choices, the ability to evaluate and distinguish between different ETFs is becoming increasingly important.

Since arriving in the region in 2009, Deutsche Bank db x-trackers has established itself as the largest provider of ETFs in Hong Kong and Singapore in terms of product offerings. Deutsche Bank ETFs listed in Asia are UCITS III funds that are legally based in Europe (Luxembourg) and cross-listed on major stock exchanges across the continent. By bringing its supermarket of ETFs to Asia, Deutsche Bank is not only contributing to the development of the ETF market in Asia but also allowing investors in the region to trade ETFs tracking Asian-underlyings with real-time liquidity.

As the largest European ETF provider in Asia^*, where investors are typically more familiar with US ETFs, Deutsche Bank has sought to present to Asian investors a balanced picture of the distinguishing features of the two markets. Major differences exist between the US and European ETFs. First, while more than half of US ETF investors are retail, the European ETF market is dominated by institutional investors. An estimated 50-70% of ETF trades in Europe is done Over-the-Counter (OTC), and is thus not reflected in the volumes reported by the stock exchanges^*. The existence of a vibrant OTC market as well as the presence of market markers who are obligated to provide continuous bid/ask quotes in most European stock exchanges (the same obligation applies in some Asian stock exchanges such as Singapore), means that investors in Europe focus more on the price rather than the volume traded of the ETF itself. They understand that the liquidity of an ETF does not depend on the volume traded in the ETF but on the liquidity of the underlying assets.

We observe that investors in Asia often choose which ETF to invest in based on the exchange turnover of the ETF without carefully analyzing the available bid/offer, trading size or importantly, how closely the price of the ETF reflects its net asset value (NAV). Thus, we often find investors in Asia buying or selling ETFs on US or European stock exchanges because of the larger volumes generated in those markets.

However, by doing so, the investors will often trade at a risk price that is based on estimations because the markets of the underlying assets are closed (e.g. trading an ETF linked to a Korean index during US market hours). In order to achieve a transparent price, investors should trade an ETF when the markets of the underlying assets that the ETF tracks are open. This explains why it is more advantageous to trade ETFs linked to Asian underlyings on Asian ETFs stock exchanges.

A second major difference between European and US ETFs is their structure. The majority of European ETFs use a synthetic replication structure developed with the assistance of European investment banks as an alternative to the traditional physical replication ETFs favored by providers in the US. While synthetic replication ETFs were designed to provide more accurate index tracking, they also gained popularity because of the access they provide to underlyings which would otherwise have been challenging to replicate through direct investments (e.g. alternative investments such as hedge funds). The innovation allowed by the emergence of synthetic replication ETFs is reflected by the fact that there is a wider product range in Europe compared to the US, even though the US ETF market is older and larger. It is interesting to observe that even in Hong Kong and Singapore the majority of ETFs authorized for public distribution by local authorities utilize a synthetic replication structure.

Risk management is another consideration for investors especially in light of recent market events. Both physical and synthetic replication ETFs have potential counterparty risks – physical ETFs because they typically engage in securities lending and synthetic replication ETFs due to their use of swaps. Both structures are required to mitigate this counterparty risk through collateral. Almost all European ETFs as well as the majority of funds distributed in Asia are UCITS III compliant.

UCITS III, the European fund directive which regulates the funds distributed across the 27 European Union countries, is widely respected as a symbol of quality-assurance worldwide and restricts the maximum net single counterparty exposure for all ETFs (including synthetic replication ETFs) to 10% of the fund’s total net asset value. Often, synthetic replication ETFs providers such as Deutsche Bank will actually place more collateral than what is required under the directive and publish information on the collateral on their websites.

By emphasizing the importance of analyzing ETFs for their real liquidity, tracking error, counterparty risk, and tax treatment (European ETFs are often domiciled in Luxemburg or Ireland and are generally speaking more tax-friendly than US ETFs for an Asian investor), we hope investors in Asia will be able to make better informed decisions when it comes to their ETF investments.

^* Source: Deutsche Bank Research, March 2010

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