Investors want to see new types of exchange-traded funds listed in Hong Kong – such as sector and small-/mid-cap products, but ETF providers need to be able to trade the appropriate underlying assets, note market participants – and that’s not always easy.

“[ETF] issuers should be working towards creating more diversity in the product suite,” Warren Deats, Hong Kong-based director of delta-one trading at Merrill Lynch, speaking at a roundtable* hosted by index provider China Exchange Services Co (CESC) and AsianInvestor.

One area where Deats wants to see development is in sector ETFs under the renminbi qualified foreign institutional investor (RQFII) scheme. Liquid, shortable sector ETFs would be useful, he says. “Investors would be able to use them for sector expression and more customised hedging. For me that is the next stage – sector expression in China.”

This product range is growing, with providers such as China Asset Management, China Universal and E Fund having launched or in the process of launching sector ETFs.

Deats also wants to see more opportunities for “size bias expression” – the ability to trade large-caps versus small-caps, or mid-caps versus large caps.

Indeed, CESC is working on developing mid-cap indices, says Henry Hui, the firm’s head of product development, also speaking on the roundtable. He notes that mid-cap China A-shares or Hong Kong stocks have had better performance and even liquidity than large-caps.

“When it comes to structural reform, in China the large-caps are mainly state-owned enterprises,” adds Hui. “But the current reforms are focused on private-sector development, and the mid-caps and small-caps companies dominate the private sector. So from a macro and past performance point of view, mid-caps will be a good alternative choice for investors.”

Curtis Tai, manager of sales and marketing at China Asset Management (Hong Kong), points to fixed income ETFs as another new area of product development.

However, “one issue with moving into new areas is that you need the ecosystem, so the market-makers are able to efficiently hedge their positions”, says Tai.

“At the end of the day, most people still don’t have quota to be able to trade the underlying basket or hedge their positions,” he adds, “so if I launch an ETF, traders have difficulty quoting the bid/ask spread tightly.”

The problem is finding the “ecosystem” to be able to trade, say, fixed income or mid-cap ETFs, notes Tai. “If you can’t borrow or short it, it’s just another ETF that is going to sit there and not trade.”

One way to seek to deal with these issues is to build a “product ecosystem” around new indices, such as futures and options on mid-cap indices, says Hui. Tai agrees such instruments will help.

Another issue around launching new ETFs is that of investor – and market-maker – education with regard to the underlying assets being traded.

Fixed income products are gaining in popularity, but the underlying basket is often difficult to understand, says Deats. “To be successful, it will require a huge amount of investor and, to be fair, market-maker education.

“Market-makers are typically equity traders,” he adds, “so we need to educate ourselves on the fixed income space and integrate with our fixed income desks.”

*For the full roundtable discussion, please see the latest (December) issue of AsianInvestor magazine.