News: Facilitate more market-making and use AI to develop ETF industry

This article first appeared in Personal Wealth, The Edge Malaysia Weekly, on July 23, 2018 - July 29, 2018.
-A +A

The proposed review of the Main Market Listing Requirements and the Rules and Directives of Bursa Malaysia Securities Bhd in relation to exchange-traded funds (ETFs) could attract greater investor participation, say industry players. Nevertheless, they believe more could be done to improve the ETF landscape as a whole.

Last year, a task force on ETFs comprising Bursa Malaysia, the Securities Commission Malaysia and other market participants made several recommendations to enhance the ETF industry. They included promoting the issuance of new and more innovative structures such as futures-based ETFs, physically backed commodity ETFs and synthetic ETFs.

Danny Wong, CEO of Areca Capital Sdn Bhd, welcomes these recommendations. He says these products would offer investors more options.

He adds that the proposed enhancements to Main Market Listing Requirements bode well for the industry. “The proposal to change the reporting requirements of these products from a quarterly to a semi-annual basis would make the work of ETF providers easier. This, in turn, would encourage more listings on the local bourse, which would benefit investors.”

Ian Yoong, an ex-investment banker with more than 20 years of industry experience, agrees. “The recommendations are sound and could make the ETF industry more vibrant,” he says.

Bursa Malaysia recently issued a consultation paper seeking public feedback on its proposed review. Its proposals included enhancing the contents of interim and annual reports arising from various new ETF products and their specific requirements as well as improving the immediate announcement requirements to promote greater transparency in relation to the indices or benchmarks tracked by the ETFs.

The proposed amendments to the Rules and Directives of Bursa Malaysia included introducing qualifying criteria for investors of leveraged and inverse ETFs as well as expanding the Permitted Short Selling framework to allow market makers to short sell all types of ETF units. Currently, the framework only allows market makers to short sell equity-based ETFs.

However, 28-year-old active investor Chua Zhu Lian feels “quite indifferent” about the proposals. “They are only addressing the supply problem, but the real problem is the demand side [as there aren’t enough ETFs listed on the local bourse and investor awareness remains low].”

 

More market makers needed

On what could be done to increase investor interest in ETFs, Yoong suggests that the bourse attract more market makers to the industry to facilitate liquidity and narrow the gap between the bid and ask price.

Yoong says market-making activity on the local bourse is currently insufficient and the spread between the bid and ask price is wide. “There have been instances of sellers taking two to three market days to sell 200,000 shares. This is not enough. There should be more market makers and more active dealers.”

Market makers facilitate trading activities on the secondary market by performing arbitrage. They are usually investment banks, whose role is to provide liquidity to the market.

Wong says when there is more market-making activity, there is more trading volume and liquidity. And greater liquidity leads to tighter bid and ask prices, which could benefit investors.

He adds that market makers should be disciplined when performing arbitrage and provide liquidity to the market, instead of behaving like ordinary investors, who hold on to shares during a bull market and sell them fast when the market goes south.

“For instance, when the index rises, a market maker could be holding on to the ETF’s underlying basket of stocks instead of performing arbitrage. They may want to hold on to it longer until it appreciates before selling it. This defeats the purpose of being a market maker. They should profit from arbitrage and provide liquidity to the market, instead of going long,” says Wong.

Yoong suggests that market makers use artificial intelligence (AI) in their activities. AI solutions could help market makers identify arbitrage opportunities and execute trades automatically without any greed or emotions involved. The technology could also help market makers execute trades faster and perform arbitrage more efficiently with lower risk.

“This could be the way to go if the major obstacle in market-making is people. Indeed, if AI is implemented, a wider range of ETFs can be introduced seamlessly,” says Yoong.

Both he and Wong say the local bourse should find ways to revamp and improve the market-making structure before introducing a wider range of products.

 

Greater transparency and awareness

Wong is also concerned about the level of transparency regarding product disclosures and financial reporting, especially when it comes to futures-based ETFs. He says these ETFs are more risky and tend to be structured in a manner that is not easily understood by the man in the street.

He adds that these ETFs, as well as leveraged and inverse ETFs, are inherently derivative products that are deemed too risky and complicated for retail investors. “I am concerned whether retail investors are able to understand how they work and the risks associated with them. Maybe a one-time leveraged ETF could be introduced to them. However, two to three-time leveraged products may be a little too much.”

Essential information on these products, including the actual tracking error and trading and brokerage cost involved, should be reported precisely in the ETF’s interim and annual reports. “I believe the cost of structuring futures-based ETFs is higher as the fund manager may need to roll over certain contracts. Trading costs such as these must be addressed precisely in their reports,” says Wong.

Chua says the local bourse should find ways to educate investors on ETFs and passive investing to solve the problem of low demand. He points out that many retail investors do not know what ETFs are and how they work.

“For those who know about ETFs, they are more familiar and comfortable with active investing compared with passive investments. ETFs and long-term passive investments remain a foreign concept to many retail investors,” says Chua.

There is also a low level of awareness among high-net-worth individuals, says Yoong. The local bourse will need to find ways to educate this group of investors on ETFs and passive investing.

“Launching more ETFs will not generate interest. However, investor awareness and acceptance will lead to greater participation in the primary and secondary ETF markets,” says Yoong.

Wong concurs. “Awareness is a fundamental issue for the ETF industry to take off,” he says.

 

Foreign funds should take the lead

Julian Ng, a financial consultant and former fund manager, has two things to say when it comes to ETFs. First, Bursa Malaysia should implement measures that would encourage more foreign fund houses to list their ETFs here, instead of encouraging local fund houses to manufacture products.

That is because it is unlikely that local banks and fund houses can provide as many ETFs as the international banks and fund houses can as they lack the infrastructure to do so. Thus, there could be insufficient liquidity, which would translate into a wider gap between the bid and ask price. As a result, investors would prefer to trade overseas ETFs or markets with much higher liquidity and tighter spreads.

“For instance, there is no way the local [financial] ecosystem can sustain market-making for, say, the S&P 500. They could launch the FBM KLCI ETF, which only requires them to buy and sell 30 constituent stocks of the index,” says Ng.

“However, would they be able to trade the 500 stocks listed in the US and provide ample liquidity to the market? Even if they could, they would most likely be offering substandard products.”

Second, the local bourse should list ETFs that “cater for the financial planning needs of ordinary Malaysians and their proxy financial advisers before looking into the needs of sophisticated investors and traders”, says Ng. The reason behind this is for the bourse to have a clearer positioning among its regional peers such as the Singapore Exchange and Hong Kong Stock Exchange, instead of just launching a variety of products aimed at attracting investor attention.

“In Asia, the Singapore, Hong Kong and Tokyo stock exchanges already have a variety of futures-based and commodity-based products. Thus, one way for the local bourse to move forward is to focus on the financial planning needs of local folks and come out with products that cater for these needs,” says Ng.

The aim of Bursa Malaysia’s ETF policy should be to allow Malaysian retail investors “to DIY a global and innovative portfolio and provide them with the building blocks for the most efficient asset allocation”. This compares with prioritising the needs of sophisticated investors and traders.

“These people are in the minority and they can go for more efficient and innovative instruments that are listed globally anyway,” says Ng.