Japan ETF managers intent on recapturing trading flows

Tokyo-based operators engage in some soul-searching after US-domiciled funds emerge as the chief beneficiaries of a jump in trading after the March disasters.
Japan ETF managers intent on recapturing trading flows

Japanese ETF operators are striving to recapture flows from Asian investors after US-listed products emerged as the chief beneficiaries of a jump in trading following the triple disaster this March.

Volumes in Japan-focused exchange-traded funds hit an all-time high as investors sought to play an evolving situation after the March 11 earthquake, which triggered a tsunami and resulted in a nuclear failure at the Fukushima Dai-Ichi power plant.

But what disappointed managers of Japan-domiciled ETFs the most is that the bulk of inflows went into products trading not in Japan, but the US.

For example, the largest US-listed Japan ETF, the iShares MSCI Japan Index – trading under the ticker EWJ on the New York Stock Exchange – saw assets under management increase by $2 billion to $6.9 billion as of September.

“We are concerned about Asian investors going to what we think is a good product, but that has structural disadvantages compared with a Japan-domiciled ETF,” says Koei Imai, head of Nikko Asset Management’s ETF Centre.

“For a US-domiciled investor, a Japan equity ETF listed on the NYSE is probably a better product because you’re trading in the same timezone. But for Asian investors we think there is a case for investing into a Japan-domiciled ETF.”

Nikko Asset Management is the second-largest ETF operator in Japan, with $7.4 billion in AUM, after Nomura Asset Management with $17.5 billion.

Both managers have seen gains this year, with Nomura’s tally up 5.8% through the end of August, and Nikko’s total up 13.5%.

But the direction of flows to US-domiciled products after the crisis “has forced us to think really hard”, Imai confirms. “What is the cause of the flow going through New York rather than coming into Tokyo directly?”

Institutional investors based in Korea, Hong Kong and Singapore all use Japan-focused ETFs extensively, as do long-only mutual funds, Nikko notes.

One factor driving investors to place their money in US markets may be the fact that they are far more liquid, making it easier to trade ETFs in large volumes.

It is also likely, though, that the trading volume of Japan-domiciled ETFs may be underreported given that a lot of trading takes place off-exchange.

According to Nikko, around $700 million in daily volume changes hands over the counter (OTC), with a further $200 million in inter-exchange trading not using on-screen exchange prices.

It is known that Japanese institutions prefer the greater flexibility of OTC trading, where there’s no on-exchange transaction charge, no minimum investment unit and trades can be negotiated in increments of less than ¥1.

Yet by trading in the same timezone as the underlying index, tracking error and spreads are reduced – pointing to the benefits of investing in Asia-listed Japanese ETFs compared with US-listed products.

The US government also charges a tax on dividends, typically at 30%. That comes on top of a 7% tax levied by the Japanese government. Assuming a typical 2% yield on Japanese stocks, a Singapore-based investor would receive a yield of 1.86% after paying the Japanese tax. But the imposition of the US levy reduces the payout to 1.30% – a 50bp spread that can make a big difference for large institutional positions.

But so far Asian investors have not been swayed. Nikko suggests that’s because Japanese asset managers have not done a good enough job of marketing their products in Asia.

“These advantages are not well known among the investment community,” Imai concedes. “Collectively as Japanese ETF providers, perhaps we have not done a good enough job explaining the benefits of investing in Japan-domiciled ETFs.”

Marco Montanari, head of Deutsche Bank’s ETF business in Asia, agrees that there are good reasons for Asian investors to shift their focus.

“We have been educating investors for the last two years on the timezone advantages and tax advantages of trading ETFs linked to Asian underlying in Asia, instead of the US or Europe,” he says.

While Japan is the largest ETF market in Asia with $31.2 billion in AUM, it is not the most active. South Korea, with 91 ETFs, now has heavier trading and more listings than Japan, which has 90 funds, according to the latest figures from BlackRock.

Almost all the products in Korea have very small sums of money under management – those listings post only a combined $7.7 billion in assets. The most successful products in terms of volume and assets in Korea are its leveraged and inverse, or short-focused, funds.

Those are used extensively by day-traders and other short-term investors, which has propelled the Korean market to over $3.5 billion in weekly turnover, according to Deutsche Bank – roughly triple the turnover in Hong Kong, Japan and China, which are the next-most-active markets.

The Samsung Kodex Leverage ETF and the Samsung Kodex Inverse ETF are the two most actively traded funds in Asia, both with more than $1.4 billion in weekly turnover.

No other Asian domicile has yet to approve short or leveraged products. But Japanese regulators are discussing the possibility of allowing such products with the government and the stock exchanges. Although their introduction is not likely this year, it could come as early as the end of this fiscal year in March 2012.

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