State Street talks ETFs in the post-Blackrock/BGI world

Since its announcement, the Blackrock-BGI merger has been talked up as a deal that promises to change the landscape of the asset management world. Everyone involved in the fund management business has been busy assessing how much of a threat the new Blackrock/BGI entity will be, and the viability of their own business models in light of the new competitive landscape.

But nowhere has this exercise been more urgent than at State Street Global Advisors. Until now, Barclays Global Investors (BGI) and State Street have run similar sized ETF businesses in Asia and have enjoyed a cordial relationship in the region. Each pursued its own products carved out of different indices, with little overlap in investment offerings or cost competition in Asia.

Post-merger, Blackrock will bring a large book of active management business to BGI's suite of passive offerings, turning the combined entity into something that looks similar to State Street's own model in the region. The merger also comes at a time when operators like Deutsche Bank and Lyxor have been putting up their own challenge by aggressively expanding their derivative-based products in Asia. It is against these forces that State Street will likely have to revamp its strategies to maintain its market share and stay ahead.

Without directly commenting on his competitors, Sammy Yip, head of ETF business at State Street Global Advisors (SSgA) in Hong Kong, acknowledges that the assessment process is already happening and is being driven from the US. State Street is studying strategies to revamp its product suite in the region and distinguish itself from the competition -- as it has always done.

For now, the depth of the financial crisis and the Blackrock-BGI merger are focusing more investor attention on the passive management sector, and the popularity of passive investments in Asia is growing. This trend that should benefit State Street enormously.

As figures stand, State Street's performance in the ETF business is strong. Yip says trading volume in SSgA's Hong Kong ETF products grew by 299.85% in 2008 alone, compared to 39.68% year-on-year over the period between 2005 and 2007. Even against a 48.27% slump in the Hang Seng Index, State Street managed to grow its AUM in Hong Kong by 3.7%.

"The passive theme will be an enduring theme," says Hon Cheung, regional director of SSgA's official institutions group, who believes the strong spike in ETF usage recorded over the course of 2008 will stick for the long term and that investors are unlikely to go back to active management.

"Don't forget we have just gone through a financial crisis -- the cause of which in essence was that (active) investment products were very opaque," Cheung says. "I actually believe that the idea of transparency, simple exposure and experiences with active management will make asset owners fans of passive products for a much more enduring period. They will begin to allocate a much more significant core allocation to passive -- the same way as we've seen this in US and Europe."

In particular, with risk premium discounts for equities at a historic low, Cheung finds most Asian institutions are now sitting on outsized positions of what he calls "virtual liquidity" -- significantly large underweight positions relative to policy allocations for equities, and that it is only a matter of time before investors move back in.

"For institutions, the fear is more about not matching the performances of their peers because of their severe underweight in equity," Cheung says.

Asian investors have already demonstrated the willingness to use ETFs for niche and satellite exposure strategies in the past. The key factor that Yip believes will drive the size of the ETF market in the future is their willingness to adopt more beta products for core allocation strategies -- a willingness that contradicts a long-standing fondness for high alpha and absolute return products that has existed in Asia for many years.

One strategy that the company will actively pursue in order to become the preferred provider of core allocation strategies is cross-listings in the region.

The company has recently taken the initiative to cross-list its ABF Pan Asia Bond Index Fund (Paif) from Hong Kong in Japan -- a market where the competition for ETF penetration in the institutional sector is the rifest in Asia.

Cheung says the fund has been recording strong inflows from Japanese institutional investors, particularly banks and insurance companies that are increasingly attracted to the Asian bond story and the ease of access the Paif architecture offers.

Asian governments' strong fiscal positions and the attractive returns over currency exposures are turning more institutional users to Paif, an ETF that invests primarily in local currency government and quasi-government bonds in eight Asian markets, including China, Hong Kong, Indonesia, Korea, Malaysia, Philippines, Singapore and Thailand. In particular, for investors keen on the potential appreciation of the renminbi, it is a rare freely-traded product that provides investors with highly transparent and liquid direct access to China's interbank market, where up to 96% of Chinese Treasury bonds are traded.

With more talk in the market of a revamp of qualified domestic institutional investor (QDII) policy, and as product advisor to the very first domestic ETF in China, State Street is also eyeing developments in the mainland. Market talk suggests that the preference for the second stage of QDII development will tilt towards passive strategies.  

Though, without a fully convertible currency regime and parallels in market settling mechanisms, full-on cross-listing in China will remain difficult.

Overall, Alistair Lowe, global asset allocation and currency CIO at SSgA, says the firm is "cautiously optimistic" about the second half of the year.

In its tactical portfolio, SSGA is overweight in US large cap, emerging markets, immediate and high-yield credits. It is underweight on US small caps, aggregate, Reits and cash.