ETFs enjoy rising appeal – but face new red tape | Fixed Income

Exchange-traded funds (ETFs) in Hong Kong have the potential to enjoy growing asset owner interest as they seek various forms of downside protection and cheaper ways to invest amid volatile markets, say market specialists.

But aspiring investors may have to contend with the possibility of new regulations, with the territory’s regulator having warned key market players of their responsibilities to ensure a smoothly functioning market during the pandemic.

Exchange-traded product volumes have taken a hit during the spread of Covid-19, with Asia Pacific volumes falling 4% from the start of the year to $290.88 billion at the end of April, according to consulting firm ETFGI.

Such drops are not surprising during several months of major market volatility, courtesy of the pandemic. Indeed, Sophia Kim, head of passive sales for Asia Pacific at DWS, argued the ETF ecosystem had shown resilience during challenging times.

Alexandre Mincier, Paris-based global head of insurance at US asset manager Invesco, told AsianInvestor that ETF volumes looked set to play a prominent role in the months to come. “I think the outlook for ETFs is pretty positive…. I would anticipate ETFs to expand into some sort of downside risk mitigation techniques in the coming months,” he noted.

A BlackRock spokesman told AsianInvestor the fund house has seen a rising number of clients considering bond ETFs as part of their overall fixed income toolkit, which allows investors to easily price and trade a portfolio of bonds.

The likelihood of more challenging conditions could accelerate an existing trend among asset owners to use passive funds to invest in mainstream assets. ETFs offer cheap ways to invest and to diversify portfolios and are practical for investors who want to quickly take tactical positions.

The volatility in current markets could stress-test some of the ETFs on the market. Physical ETFs are subject to the liquidity of the underlying asset. Liquid risk can materialise, particularly in periods of stress and mass redemptions.

On the other hand, ETFs can offer investors a means to quickly exit their exposure to more illiquid underlying assets. Investors holding fixed income ETFs had a chance to exit their investments during March, at a time when liquidity for many individual bonds was drying out, Kim said.

"I think that asset owners could well increasingly use ETFs as a cost-efficient way of tilting their portfolios," agreed Ian Martin, global head of asset owners at State Street.

Fixed income ETF assets in Asia Pacific ex-Japan dropped 1.1% to $66.63 billion in April alone, ETFGI data shows. Across all types of ETFs, the assets have fallen 1.3% during the month.

OPERATIONAL RISK

Investors who weigh the merits of ETFs in Hong Kong may have to contend with incoming rules from the territory’s financial regulator.

The Securities and Futures Commission (SFC) issued a circular last month to remind ETF managers and market makers of their responsibility to manage the products in the best interests of investors even during the pandemic. Its warning came after a sole market maker of an ETF suspended its work due to the quarantining of some of its trading staff.

"This is, in my view, an operational risk due to the failure on the part of the market maker," said Mincier.

He noted that while the global financial crisis in 2008 was a liquidity crisis, the current crisis caused by Covid-19 particularly exacerbates operational risks everywhere.

The SFC’s circular included suggested measures such as ETF managers conducting due diligence and regularly monitoring the competence and performance of market makers. They should also keep a close watch on secondary market trading and liquidity of the ETFs under their management and adequately manage the risk of reliance on a single market maker to provide secondary market liquidity.

One consequence is that the regulator is expected to introduce new policy changes to reduce operational risks that can impact the financial instruments, including ETFs, Mincier added, without providing details.

OIL ETFS ON THE SLIDE

While investors may well increase their interest in equity and bond-based exchange-traded funds (ETFs), they are far less likely to be attracted to products based on oil assets or the commodity itself, at least in the short term.

Oil prices plummeted in April, which led US Oil Fund ETFs to fall as much as 83% for the year, according to the Wall Street Journal. And despite a recent rally in the value of a barrel of crude oil, both oil and other commodities and likely to suffer strongly this year and potentially into 2021 – until the end of the health crisis, said Alexandre Mincier, global head of insurance at US asset manager Invesco.

In the long-term, however, the ETFs are likely to rapidly gain demand once more as the Covid-19 situation gets better by next year, said Sophia Kim, head of passive sales for Asia Pacific at DWS.

That said, retail investors need to consider any investments into oil exchange-traded products carefully. These products are generally structured via futures contracts involving a maturity and a rolling cost, which is the cost incurred when investors renew or roll forward the derivatives since options have a limited shelf life, she noted.