The following article first appeared in the November 2008 edition of AsianInvestor magazine. Each month we offer online a feature from the magazine. To subscribe for more in-depth industry analysis that you canÆt find on our website, please send an e-mail to: [email protected]

So far one clear winner from the credit crisis is the exchange-traded funds industry. Although ETFs remain but a small part of the Asian investment scene, they have enjoyed net inflows even as local and global stock market indices have crashed.

This is true worldwide: according to Barclays Global Investors, by the end of the third quarter this year, global assets under management in ETFs had fallen by 4.1%, compared to a 29% drop in the MSCI World Index in dollar terms. That means net creation of ETF units has been significant; the average daily trading volume in US dollar terms has risen 106% to $123.8 billion.
BGI estimates that global ETF AUM will exceed $1 trillion in 2009, and $2 trillion in 2012.

AsiaÆs share is modest but growing more quickly than in Europe or the United States. Deutsche Bank estimates ETF AUM in Asia ex-Japan to have reached $27.5 billion by mid 2008, while JapanÆs industry is about $36.5 billion û a combined size of $64 billion that is up from $59 billion in January, about 11% growth; this trend has accelerated in the second half. Considering the even more extreme falls in Asian stock markets, this is impressive.

Why are ETFs enjoying a boost to assets when the markets they are tracking are in the dumps? First, the broadest ones can be liquid û unlike many emerging stock markets. Second, they offer very cheap beta. Both factors have become critical this year.

Consider the financial sector, and the litany of collapses, acquisitions and bailouts. Most investors have no idea which bank could be the next to go. Running a portfolio of a few banking stocks is now highly risky. Yet long-term investors still need some kind of market exposure. Moving to ETFs can provide that, as well as the safety of a broad exposure.

But ETFs remain a tough sell in Asia, where so many investors remain sceptical of passive investing, and where the fragmented nature of the regionÆs markets and regulations makes it difficult to build scale or liquidity anywhere except in Japan. Ken Yap of consultancy Cerulli Associates notes that the equity mutual funds business is about $450 billion in Asia ex-Japan. ôETFs have a long way to go before they reach a critical mass,ö he says.

The industry began in 1998 when Hong Kong and Japan introduced ETF products. The first movers were American firms BGI and State Street Global Investors. The US ETF industry was born in 1993 with SSgAÆs SPDR tracking the S&P500. The market is so large and deep, that plenty of brokers were willing to participate û especially after 2000, when BGI introduced the iShares series, launching 55 ETFs in the space of six months.

But Asia is fragmented, with each market having only room enough for one or
two broad indices. These are dominated by a handful of players: Nomura Asset Management and Nikko Asset Management in Japan; SSgAÆs $3.6 billion Hong Kong Tracker Fund; BGIÆs iShares Asia trust, also listed in Hong Kong with $3.4 billion; and Hang Seng Asset ManagementÆs $4 billion in Hong Kong- and A-share ETFs. But by 2002 the market was carved up and these players hit a wall.

Today a combination of deregulation and the arrival of European players is shaking things up.

Lyxor Asset Management, a unit of Societe Generale, was able to cross-list European-domiciled ETFs starting in 2006. Deutsche Bank is now following with its db x-tracker series, as is BNP Paribas to a lesser extent.

Europe, like Asia, is fragmented, which has reduced the attractiveness among broker/dealers to support ETFs. Therefore the market had to develop a different way, with banks relying on their own brokerage arms to make markets in ETFs. Regulators were satisfied with this arrangement so long as the necessary Chinese walls protected investors. Only committed market makers could generate liquidity for ETFs, while EuropeÆs Ucits code allowed fund managers to build scale, by marketing a single fund across markets.

Now that Asian markets such as Hong Kong and Singapore accept most Ucits products, it has become inexpensive for Lyxor, Deutsche and BNP to cross-list the same European-domiciled ETFs to Asia, particularly in markets where they have a local brokerage capability. The model is the same as in Europe.

But the goal is the same as in America: to create a huge variety of products that can be used by institutional investors as tools. ôIn the US, institutional investors can allocate between large-, mid- and small-cap ETFs, or to ETFs that short, or to ETFs for growth or value stocks, or themes û they can mix and match exposures to create value,ö says Joseph Ho, managing director for ETF sales and marketing in Asia at Lyxor.

For example, a money manager with a US small-cap equities portfolio usually needs to hold some cash. But instead of doing so, it could put that money into an ETF tracking the Russell 2000, which is sufficiently liquid that it can be immediately sold if the manager faces redemptions.

ôInvestors can use ETFs as liquidity tools,ö Ho says. But so far, Asian institutions are not using ETFs this way. The product is still viewed by investors as a window to niche asset classes.

More products and more liquidity are required before ETFsÆ potential is realized. This is happening, but it will take time. Deutsche wants to bring its credit bond ETF from Europe as well as create Asian versions, while BNP Paribas has introduced an Islamic ETF in Malaysia.

Their activity is spurring the American players to do the same, despite their lack of a large broking operation: SSgA recently cross-listed a NYSE-based gold ETF in Hong Kong, Tokyo and Singapore, with Citi appointed its official participating dealer. ôMore brokers need to dedicate resources to this,ö says Sammy Yip, regional head of ETFs at SSgA.

Most importantly, once investors start to use ETFs, they are going to continue to do so.

The credit crisis has catalyzed awareness of ETFs, which will in turn convince more brokers to support these products. The industry in Asia may be on the cusp of something extraordinary.