In the vast world of securities and investments, exchange traded funds (ETFs) do not enjoy the same ubiquitous recognition of mutual funds or common stocks, but that is quickly changing.
Last year the ETF industry underwent explosive growth, with assets under management increasing 40 per cent to $796.6 billion (Dh2,926bn) and according to a senior banker at Morgan Stanley, the UAE, Saudi Arabia and Egypt are working on the regulatory framework to allow these funds to list on the region’s bourses.
Deborah Furh, Managing Director at Morgan Stanley, one of the world’s top experts in the ETF industry, has been tracking the funds for 11 years – the first ETF, the SPDR S&P 500, was listed in 1993.
When Fuhr first started looking at ETFs, there were only 21 listed products with assets of $8bn – today there are 1,173 trading on exchanges in the US, Latin America, Europe, Asia, Australia and South Africa. None of the bourses in the Middle East have an ETF listing, but Fuhr said this will change soon. Fuhr, a member of the advisory council for the Cairo and Alexandria Stock Exchange (Case), said Egypt has developed the regulations to allow an ETF listing and is ready for proposals from fund managers. “The Case will get their ETF out this year, and I would expect that ETFs will be launched on a number of exchanges in the GCC this year.”
Fuhr noted the Dubai International Financial Exchange (DIFX), the Abu Dhabi Securities Market (ADSM) and the Saudi Tadawul have expressed interest in having the passive index funds on their exchanges. ETFs are desirable not only because they are transparent, liquid and simple instruments, but they also increase trading in the underlying portfolio that increases trading volumes and generates more fees for the region’s exchanges.
The funds also act as diversification strategy that incorporates entire markets, investment styles and sectors.
For local investors, the appeal of gaining exposure to a diversified instrument that incorporates entire markets, investment styles, and sectors is apparent, but Fuhr said the region’s exchanges are considering to cross-list global ETFs as well that offer quick access to the international scene. For the foreign investor who does not have a good grasp of the Middle East’s stock markets, a locally managed ETF would give exposure to countries and indices. As many markets in the region have foreign ownership restrictions, the underlying assets of a local ETF would allow foreigners to circumvent these limitations.
According to Fuhr, the biggest obstacle to an ETF listing in the region is regulatory, but she believes this will be overcome soon. Regulators “have so much going on now that finding the time to make changes is difficult”.
But the growth in the industry worldwide gives a definite sense of the inevitable introduction of these tools in the region. The 1,173 ETFs available are listed on 75 exchanges, and there are plans to launch a further 525 ETFs: 87 in Europe, 381 in the US and 57 in the rest of the world. Fuhr believes ETF assets under management will exceed $2 trillion in 2011.
In 2007, the worldwide 20-day average daily trading volume in US dollar has increased by 143.2 per cent to $59.7bn from $24.6bn at year-end 2006.
The US has the largest number of products and assets under management – 601 ETFs and $580.7bn, followed by Europe with 423 ETFs and $128.4bn and Japan with 15 ETFs and $34.2bn. The first ETF, the SPDR S&P 500, had almost $100bn in assets under management as of December 31, 2007.
Institutional investors have been active in the industry for many years. More than 2,200 institutional investors worldwide reported using one or more ETFs last year. Hedge funds have also been deploying cash into ETFs, and reported a 36 per cent increase in the use of the listed funds last year.
Fuhr said regulators in emerging markets are encouraging their pension funds to use ETFs. “In Latin America, they encourage pension plans to use ETFs for other emerging market exposure.” The Chinese have started using ETFs through their QDII (qualified domestic institutional investor) scheme that allows capital to leave the communist nation. And Fuhr noted sovereign wealth funds in the Middle East and Asia have used ETFs to “quick exposure to certain markets”.
The attributes that attract the institutions are also attractive to retail investors. When Fuhr described ETF, she said: “They’re simple, flexile, transparent, liquid, low-cost, and they are not a derivative.” Last year’s implosion of complex structured financial instruments is still reverberating throughout the world, causing many investors to flock to simpler, more transparent investment vehicles. This dynamic has led retail investors to look at ETFs and allocate at least a portion of their portfolios to these funds. Some investors have exited normal funds as one rationale for leaving the realm of actively managed funds as ETFs has been gaining traction over the past few years.
Fuhr mentioned the quarterly survey of actively managed funds conducted by S&P in the US that consistently shows 70 per cent of these managers “do not beat the S&P 500, so if you are paying active managers a lot of money – 5 per cent fees, 2 per cent fees, whatever it is to beat the index and you don’t, then why not use a low-cost passive fund that at least tracks the index.” The SPDR S&P 500 ETF costs just 9.5 basis points “so investors are basically getting the index.” There are ETFs that give exposure to the MSCI World, which comprises a huge basket of shares, for 200 euros and an annual cost of 50 basis points “so it is very cost efficient.”
While active managers are still able to raise funds, Fuhr thinks the industry is under pressure. “But the portfolio managers are compelling when they are out there talking to investors, so I think the competition will continue to be there,” she added.
With lower costs and arguably superior performance than traditional funds, ETFs are well positioned to break into the Middle East this year. Once the regulations are enacted, the only challenge that remains is finding a good index and launching a fund. Fuhr believes the underlying index is the key because the region is awash with liquidity. “For a fund to break even it needs to have at least $50 million to cover costs, so it doesn’t have to be huge to be successful.”
What are ETFs?
ETFs are open-ended index funds that are listed and traded on exchanges like stocks. They allow investors to gain broad exposure to a variety of indices. ETFs cover equities, commodities, countries, sectors, styles, fundamental indices, dividend indices and provide leverage exposure. ETFs give access to international emerging markets and corporate credit. “Commodities are some of the newer products available – you can buy exposure to the Goldman Sachs commodity index, energy indices and agriculture and livestock indices,” Fuhr explained.
ETFs, unlike traditional actively managed funds, are transparent as the managers provide the ETF portfolio composition to the market on a daily basis. The annual fees are less than actively managed funds and normal index funds. Most other funds only allow investors to buy in and exit once a day at one price, but because ETF function like a stock, investors can buy whenever the market is open and participate in wider range of trading.
“In markets where shorting is allowed, you can also short the ETF. For many investors, including hedge funds, being able to go short is a big attraction for ETFs,” said Fuhr.
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