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Hong Kong's market for ETFs is catching on
20 May 2007
South China Morning Post

Exchange Traded Funds (ETFs) are beginning to catch on in Hong Kong.

Last month, France-based Lyxor Asset Management listed on the city stock exchange six ETFs, tracking global, regional and commodity equities. Not only did this drastically boost the total number of ETFs available in Hong Kong to 15, it also broadened investors' choices.

Tracking core areas such as the S&P 500, MSCI World, MSCI Asia ex-Japan as well as commodities, they provide fund investors with vehicles to adapt quickly to market conditions. Compared to the pace of growth in major overseas market like the US, however, Hong Kong is well behind. In 2006 there were 159 ETFs launched in the United States, triple the amount in 2005. As of last month, the total ETF asset under management in the US surpassed US$470 billion, an increase of more than US$100 billion from last September.

The reasons that US investors have become enamoured with ETFs are numerous. An ETF is a hybrid of a stock and a mutual fund. On one hand, it is as diversified as an index fund because it is comprised of a basket of securities. On the other hand, by being listed on a bourse, ETFs can be intra-day traded, like any stock. Traditional mutual funds settle only at the day's close. Investors do not pay upfront sales charges for ETFs except brokerage commissions and annual management fees are usually lower than 1 per cent since they are passively managed. In comparison, the average management fees for equity and fixed income funds in Hong Kong are about 1.62 and 1.23 per cent respectively.

Because of the stock-trading feature, an ETF's pricing mechanism is different from traditional funds. The price of a mutual fund is by definition the fund's net asset value (NAV), or the worth of its portfolio. An ETF's price, on the other hand, is determined by supply and demand on the market, which is why the price may differ from NAV. An ETF that trades at a price higher than its NAV is said to trade at a premium, or if it is lower, at a discount. The potential for arbitraging ensures that even though there are slight discrepancies, the market price of an ETF is usually very close to its NAV. When the price of an ETF is higher than its NAV, an arbitrageur will sell the ETF units and buy the underlying portfolio of stocks, effectively forming an ETF unit in a process called in-kind creation.

The reverse, called in-kind redemption, is done when the ETF trades at a discount to its NAV.

However, spreads could be significant for funds in which the underlying holdings are not easily accessible. One such case is the iShares FTSE/Xinhua A50 China Tracker fund. It is linked to A shares, which are nearly exclusively available to mainlanders.

As of May 15, the average absolute spread for Hong Kong-listed ETFs other than the A50 China Tracker was 0.41 per cent compared to a 9.14 per cent discount for the A-share fund.

Because it is difficult to arbitrage, international investors have been using it as a proxy for how they feel about the mainland market. In April, with rising concern about a bubble in the mainland, the A50 China Tracker traded at an about 15 per cent discount. In January, when sentiment was still bullish and the average daily trading volume more than double over last year, it traded at about a 20 per cent premium.

Another factor that contributes to the wide spread is the fact that the tracker fund does not actually own the shares directly. As only Qualified Foreign Institutional Investors (QFII) can invest in the A-share markets - and only a limited amount - the A50 China Tracker holds what are called Chinese A-shares Access Product (CAAP), which synthetically replicate the performance of FTSE/Xinhua A50 Index. That makes it a less reliable mirror than other types.

Jessy Yang is head of research at fund-rating firm Morningstar Asia
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