The what, why and how of exchange traded funds

Rebecca Sin, from Commerzbank’s ETF Sales Trading Asia Team, is a keen advocate of exchange traded funds (ETFs). She made a presentation to the Hubbis Investment Solutions Forum providing Asia-based high-net-worth individuals with further information on ETFs and trading strategies. 

The global ETF market – covering equities and fixed income funds – has enjoyed a remarkable explosion in volumes to surpass a market share of USD 5 trillion today. What are ETFs? They are securities that track the value of an index, commodities or a basket of assets and trade like a stock on the exchanges. Many ETF advocates see a great potential for them in Asia, where they are underutilised, arguing that they are the perfect tool for portfolio construction, being cost-effective, liquid, transparent, and versatile in terms of asset class label.

A USD-5-trillion juggernaut rolling into Asia

The USD-5-trillion ETF industry began life only 30 years ago and a decade ago was worth around USD 500 billion. Since the global financial crisis, a decade on has brought the most explosive growth. But Asia is only a small portion of the overall market so far, and therefore offers opportunities for growth.

One core reason for the ETF explosion is the ongoing shift over the past 10 to 15 years from active to passive investment. This means that distributors, independent financial advisors (IFAs), advisers, and private banks have moved, or are moving globally, to fee-based advisory. It is a sensible shift from a situation where the product issuer has been paying rebates, which is also known as retrocession fees, to the distributors who then sell their products to investors. This is driven to a considerable extent by regulatory tightening on rebates and other ‘hidden’ fees passed between product creators and the advisory community – that for example has helped the Australian ETF market volumes soar in recent years.

How does an ETF act? Fundamentally, it acts like a combination of a mutual fund and a stock. But an ETF can be traded at any time, whereas a mutual fund only has one price at the end of the day, meaning there is more liquidity and transparency in ETFs.

Additionally, ETFs act as building blocks of portfolios: there are active products, passive ones or both. ETFs can be used as a building block of a portfolio for diversification, quick market access, tactical asset allocation, and cash equalisation. For example, if there is cash in a portfolio waiting to be deployed in the right active stock selection, that cash can be parked temporarily, in ETFs until an active strategy is found, or perhaps an anticipated event leading to a market change, for example if it’s expected that Italy will bounce back after a spate of bad news, but there’s no time for the due diligence required to buy individual stocks, an ETF can be used instead to express views on the country as a short-term play.

And thirdly, as ETFs are passive products that by definition will not beat the benchmarks, over time they are cost-efficient, for example, an investor can buy the S&P 500 at just four basis points. Thus, passive ETFs can be much cheaper relative to similar active products, they are also diverse, liquid, and tax-efficient.

Strategies for choosing ETFs

Selection of an ETF, however, is more complex: many make the mistake of selecting the ETF based on assets under management (AUM) and the management fee, thereby choosing the largest ETF with the cheapest management fee, all of which seems to make sense. But there are strategies that will help wealth advisers and their clients more accurately and logically to select ETFs.

Secondly, one has to consider exposure: do you want a physical or a synthetic ETF? Physical replication is the most common and popular. For example, if you buy an S&P 500 ETF, the ETF will physically own all 500 names of the index. On the other hand, a synthetic ETF will utilise derivatives such as futures and swaps. For example, as the logistics effort to move barrels of oil is too expensive, the most cost-efficient way to do this is via a swap. For example, if you want exposure to oil, a practical form would be a synthetic ETF. 

Thirdly, what type of ETF do you want to buy? Is it smart beta, leveraged/inverse, currency or commodities? There are many different structures to invest into, so make sure you pick the right structure for the exposure you want.

Fourthly, one has to consider performance, i.e. the total cost of ownership. Many simply look at the management fee and AUM, but disregard how much it costs them to trade in and out of the ETF, the tax implications, the bid-ask spreads. So, when you think of an ETF, you have to look at these various components to determine if the ETF is suitable for your portfolio.


Finally: what about liquidity? The key point here, without going into technicalities is that ETFs are as liquid as the underlying. It may seem like an ETF is illiquid, especially when you check in Bloomberg or other data sources but as a market maker Commerzbank can provide liquidity on ETFs, even when markets are closed. Via our proprietary platform, we make markets in 4,000 ETFs globally across all asset classes thanks to our state-of-the-art electronic trading platform. Furthermore, Commerzbank offers research and advisory, and also provides custom solutions on ETFs to help clients build the right portfolio for their needs including model portfolios, custom baskets and funds of funds.

Asia – a region of immense potential

Asia is a region of immense opportunity for ETFs, having lagged the worldwide ETF explosion. US still mainly dominates the worldwide landscape with a market share of more than 70%, while Europe represents almost 16% of the market. Asia meanwhile represents less than 10% of global ETF valuations.