The September 11 terrorist attacks have prompted many governments including South Korea to try and stabilize their equity markets. Among these is a Ministry of Finance and Economy (MoFE) proposal that had already been in the works, but is nowbeing pushed forward and will enable allow local investment trust companies and asset management firms to sell stock-index mutual funds.

These products, known generically as exchange-traded funds (ETFs), will be listed on the Korea Stock Exchange or the over-the-counter Kosdaq and start trading next year. However, a number of foreign fund managers and local brokers familiar with ETFs say that legislation the government is preparing to submit to the National Assembly this autumn is flawed.

ETFs in markets such as the United States or in Hong Kong (the Tracker Fund) are useful tools to reduce the impact of redemptions from stock-market investors, particularly big institutions, because of their in-kind creation and redemption process. Although ETFs are commonly used to short markets, to do so requires have an ETF unit to short, which in turn means it must be initially created from a basket of securities mirroring the index. So shorting an ETF requires brokers to buy or borrow the underlying securities, so the process is market-neutral. MoFE is eyeing ETFs now as a way to allow investors to quit the market with little disruption - thereby improving general sentiment.

Butmarket professionals point out that the taskforce set up by the Korea Investment Trust Company Association and spearheading local ETF development has failed to include trust banks in its deliberations. The role of the trustee is obscure but vital, because it is the manager of the in-kind creation and redemption process, and it must therefore have efficient interfaces with other parties, such as the ETF manager, the broker, the depositary, the clearing house and the index vendor.

The only kinds of funds listed in Korea are mutual funds, where everything is handled in cash and where trustees don't play this critical role. "Without efficient in-kind creation and redemption, then you just really have an index fund," says one fund manager in Seoul. "The net asset value may track, but the ETF will be priced at a steep discount, which defeats the purpose."

Foreign financiers are a little puzzled why MoFE is pushing the ETF at this point in time. It is a good product but it only really works when the underlying market is liquid and transparent.

They suspect the Korean government sees an ETF as a prestige item in addition to wanting to push measures that support the stock market. "The government's time would be better spent working on issues like corporate governance and ensuring the solvency of the financial system," says one fund manager. "These are the fundamental requirements for an ETF, and I don't think the regulators really understand why ETFs work in other markets."