In August 2011, Chinese Vice Premier Li Keqiang visited Hong Kong, where he unveiled plans to create an exchange-traded fund (ETF) that would allow mainland China investors to invest in stocks listed in Hong Kong.
The announcement hardly came as a surprise, as exchange-traded funds have become an increasingly popular and cost-efficient way to get exposure to equity markets. According to research consulting company Strategic Insight, the net sales of ETFs domiciled in Asia, minus Japan, were $3.1 billion from January to April 2011 — compared with negative net sales of $13.4 billion for mutual funds during the same period.
In the first half of 2011, 65 new ETFs were launched in Asian countries other than Japan. As of 30 June 2011, there are 376 listed ETFs with assets of $61 billion, representing 67 providers and listings on 13 different exchanges. Asia’s three largest are State Street Global Advisors, iShares, and HSBC/Hang Seng, with combined assets under management (AUM) of $30 billion. This is a growth area that will likely continue in the next few years with new innovations, products, and structures.
ETFs started modestly in Asia, with the launch of the Tracker Fund of Hong Kong following the financial crisis in 1998, when the Hong Kong government purchased shares, pooled them, and listed the ETF on the Hong Kong Exchange (HKEx) to stabilize the stock market. Today, the largest ETF in Asia is the A50 China ETF, which tracks the 50 largest stocks on the Shanghai Stock Exchange and is listed in Hong Kong; launched in 2004, it has had an annualized return rate of 17.9 percent since its inception.
Have Regulations Kept Pace with Innovation?
While ETFs started out as very small experiments with basic rules and regulations in most Asian markets, with the proliferation of new and innovative products based on different types of physical assets or replication strategies using derivatives, more complex synthetic ETFs are being offered to investors. In response, critics have questioned whether existing regulations and disclosure practices are sufficient for investors to fully understand and appreciate the risks and costs. Synthetic ETFs, which use over-the-counter (OTC) derivatives and total return swaps to replicate returns on broad market indices, are more common in Asia than in the U.S. That’s because regulation allows greater flexibility to use derivatives to construct an ETF in Asia.
Some also have expressed concerns that the development of ETFs has followed a similar pattern to that of structured products that led to the Lehman minibonds crisis in 2008. Synthetic ETFs, such as the A50, attempt to deliver the index return of top 50 stocks by market capitalization in the A-share market on the Shanghai Stock Exchange by using total return swaps. This raises counterparty risks similar to those of Lehman minibonds. Sudden and large investor withdrawals, triggered by market events or concerns about counterparty risks, are untested. Crisis experience has also shown that collateral assets pledged by a failed counterparty could be frozen by a bankruptcy administrator. Securities lending to improve returns on the ETF might further complicate the process of gaining access to the pledge collateral from the swap counterparty in times of distress.
It is perhaps time to take stock of the ETF labyrinth in Asia — including the clarity of the underlying assets, structures, and risks embedded in the structures, and the transparency of information disclosed to investors in prospectuses and ongoing disclosure of performance and risk management.
Firstly, ETFs are generally less well understood by investors and there is a knowledge vacuum that needs to be addressed, in concert, by the exchanges, originators, and distributors.
Secondly, “ETF” has become a blanket term for a variety of products with different structures and underlying assets. ETFs need appropriate labeling to identify the product structure, investment objective, and underlying risks. In Hong Kong, for instance, all synthetic ETFs are required to have a “mark” to distinguish them from the others. A standard classification system, with clear labels across the region, might be a good first step.
Thirdly, most ETFs in Asia apply a manager/trustee model under their local regulatory framework. This is similar to listing investment funds on the exchange. As the market develops, it is timely for regulators to review the current framework regarding transparency, disclosures, conflicts of interests, and governance. The prospectus documents are long and complex, especially for synthetic ETFs. We need tighter regulations on continuous and periodic disclosures, especially relating to performance and risk management. Investors can benefit from adequate and timely disclosures of counterparty risks and collateral.
Finally, we should have more avenues for investors to engage with the originators, as no annual general meetings are required and the threshold to call a members meeting is 10 percent of the shareholdings, which is daunting for dispersed minority investors.
For more than 10 years, ETFs have provided an opportunity for investors to gain access to a broad range of asset classes using a low-cost investment vehicle listed on the stock exchange in Asia. Now it’s time for investors to demand changes that will help us demystify this increasingly complex market.