On July 1 Hong Kong’s exchange-traded funds market experienced the ‘Vanguard Effect’. Ironically, BlackRock initiated it. The world’s largest fund manager and provider of exchange-traded funds heavily slashed the fees on two of its ETFs listed in the city, in an apparent attempt to attract more investors.

The Vanguard Effect refers to the eponymously named fund manager instigating a cost war by cutting fees on its ETFs or index funds. True to form, Vanguard was quick to counter its arch-rival. On October 17 it followed suit on all five of its Hong Kong-listed ETFs, bringing three of them under 20 basis points.

“We’ve lowered the price [of our funds] nearly every year for the last 40 years,” Bill McNabb, chief executive of Vanguard, told AsianInvestor two weeks before the fee cuts.

The price war underscores the desire of BlackRock and Vanguard to build their passively managed assets in Asia Pacific. Since the global financial crisis of 2008, index-linked funds and ETF assets have swelled across the US and, increasingly, Europe. The reason? Active fund managers have badly underperformed.

On October 24, index provider S&P Dow Jones revealed that 97% of emerging-market funds failed to exceed their benchmarks over the past decade, along with 99% of actively managed US funds sold into Europe.

Asia lagging

Yet despite such woeful returns, the adoption of passive funds has been less pronounced in Asia than other regions – particularly among retail investors. This is partly because ETFs haven’t enjoyed as high a profile in the region, despite regularly beating their active rivals. 

But the environment could be set to change. In May, lawmakers passed a rule that required fund providers for Hong Kong’s Mandatory Provident Fund Scheme (MPF) to offer a fund that charged no more than a 75bp management fee, for all employees that don’t choose how to invest their MPF. The new products will launch in April 2017. Singapore’s Central Provident Fund (CPF) looks likely to introduce its own low-cost option.

These are likely to be index funds or ETFs – a potential fillip to mass appeal. The move could end up saving the region’s retail investors a lot of money.

The rise of passive funds across the world makes sense, considering the poor performance of active managers.

Active funds can cost Asian retail investors anywhere from 150bp to 500bp in fees, depending on how they are sold. Those are high costs – particularly considering so few funds manage to beat their benchmarks.

John Davies, managing director of global ETFs at S&P Dow Jones Indices, said: “We have looked at the performance of active funds against S&P indexes over one, three, five and 10 years and in general terms in most markets, three out of five active managers failed to beat their benchmark; it’s a damning indictment."

Passive market share rising

Investors in the US and Europe in particular have responded by buying index funds and ETFs, which often cost less than 10bp a year. Passive funds grew their share of global assets under management (AUM) from 11% in 2009 to 19% in 2015, while the AUM of ETFs has risen 25% a year on average over the past decade to exceed $3 trillion by the end of 2015, according to a September report by S&P Dow Jones Indices.

“Alpha has been hugely scarce, and it’s very difficult for asset owners to find and select those outperformers,” said Kevin Hardy, head of beta strategies for Asia Pacific at BlackRock. “And it’s also hard to sustain it. Some clients are disappointed with what they’ve gotten and have seen over time they would have been better off by adopting more passive performance.”

Asian investors are following, but to a lesser degree. As of end-2015, $243 billion was invested in ETFs across Asia Pacific, while Hong Kong alone boasted $2.24 trillion in total fund AUM, estimated BlackRock.

Part of the reason for the lower penetration is down to the shorter time for the market to develop. ETFs have existed for about 15 years in Asia, but only gained real traction since 2010, initially with institutional investors. For example, Taiwan's Labor Pension Fund, one of the six funds operated by the country's Bureau of Labor Funds, handed out its first index investment mandate in 2011. 

In part two of this feature, we look at the attitude of the region's asset owners to passive funds and at regulatory changes that could ease the resistance of retail investors. The article appears in full in the November issue of AsianInvestor magazine.