Cover Story: Profiting from market volatility

This article first appeared in Personal Wealth, The Edge Malaysia Weekly, on December 2, 2019 - December 08, 2019.
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Global financial markets have continued to perform erratically and investors are bracing for a bumpier ride ahead. In the light of such volatility, instruments such as leveraged and inverse exchange-traded funds (L&I ETFs) can be used to capitalise on these market conditions.

Affin Hwang Asset Management Bhd (AHAM) managing director Teng Chee Wai says L&I ETFs serve as a tactical window for investors to express their market views, whether by taking bolder moves through amplified exposure or betting against the market. “It gives them an opportunity to invest with stronger conviction, regardless of the direction of the market.”

Unlike a conventional ETF, a leveraged ETF aims to achieve a return of two to three times the index it tracks by using financial products and debt that magnify the gain. An inverse ETF (also known as a short ETF) uses short selling, derivative trading and other leveraged investment techniques to perform inversely to the index it tracks.

As this issue goes to print, the country’s first L&I ETFs are scheduled for a Nov 29 listing on Bursa Malaysia. AHAM’s four funds allow investors to leverage and short the market, giving them the opportunity to profit from the volatility in financial markets.

Two of the ETFs (one leveraged and one inverse) track the Hang Seng China Enterprises Index while the other two track the NYSE FANG+ Index. The leveraged ETFs provide investors with the option of having 2x leverage while the inverse ETFs allow them to hold an inverse position (-1x) on the index they track.

The ETFs that track the Hang Seng China Enterprises Index are the TradePlus HSCEI Daily (2x) Leveraged Tracker and TradePlus HSCEI Daily (-1x) Inverse Tracker while those that track the NYSE FANG+ Index are the TradePlus NYSE FANG+ Daily (2x) Leveraged Tracker and TradePlus NYSE FANG+ Daily (-1x) Inverse Tracker.

There are two ways to employ L&I ETFs as part of your portfolio strategy, says Teng. One, investors can employ these ETFs tactically as part of their overall portfolio strategy. “Most of 2019 has been a trading market, due to volatility arising from the trade tensions, recessionary fears and geopolitical tensions such as Brexit and the protests in Hong Kong.

“The smartest strategy is to buckle up, stay disciplined and invest consistently to ride market peaks and troughs. But investors who want to take a tactical view and perhaps have a clearer read of the market’s fundamentals can opt to magnify their exposure through leveraged ETFs and make bigger wins in the market over shorter time frames.”

The other way is to use inverse ETFs as a hedging tool. These ETFs offer portfolio protection, especially during bearish market trends, by allowing investors (particularly those with long positions) to hedge against losses and still keep their portfolio intact by squaring off their market position.

“From an asset class perspective, it is important for investors to look at the underlying index tracked by the L&I ETFs because while the concept is similar for both strategies, the underlying index is the key differentiating factor,” says Teng.

Through AHAM’s ETFs, investors can get exposure to the two indices through futures contracts without the hassle of trading futures themselves, as these instruments have expiration dates and require investors to take note of rollover dates, which can be outsourced to the ETF provider.

“Accessing global markets through domestically listed ETFs means convenient and hassle-free trading. As we make them available in ringgit, investors do not need to have accounts in foreign markets or convert currencies to trade,” says Teng.

AHAM focuses on delivering the 2x leverage and 1x inverse returns daily, he adds. “To put it simply, if the underlying index gains 2% for the day, the 2x leveraged ETF gains 4%. The aim is to provide daily returns. So, we reset the exposure to the underlying index daily, constantly starting the trading day with 200% exposure against the underlying index [for the 2x leveraged ETF].

“This process of resetting the exposure is called daily rebalancing. We do not promote long-term holdings for these funds as their returns over a period of more than one day are compounded due to the daily rebalancing mechanism.”

The L&I ETFs are not for conservative investors. Being able to magnify gains also means that investors could potentially magnify their losses. Hence, these strategies are only available to investors who understand how the strategies work and the high risks involved.

In view of the risks associated with these ETFs, only investors who fulfil any one of the following criteria outlined by Bursa can trade the funds. To qualify, they must be a sophisticated investor, have a margin account or have executed at least five transactions of exchange-traded derivatives or structured warrants in the preceding 12 months.

Investors who do not meet any of these requirements still have the opportunity to trade the funds. However, they must utilise a performance simulator (which simulates trading of L&I ETF units) on AHAM’s ETF website and undergo an e-learning tutorial developed by Bursa. The free tutorial is available on the Bursa Marketplace website, which offers six short videos on L&I ETFs.

“This means, in a way, it is open to all. But investors have to go through the education process so that they understand what they are getting themselves into,” says Teng.

“For these units, leverage is involved. Investors need to be mindful that if the indices go down 10%, the fund goes down double that amount. But if their view is right and the indices go up 10%, they gain 20%.

“We do not want retail investors to go in blindly. We think this is a good safeguard.”

Typically, L&I ETFs in other parts of the world impose higher management fees than the plain vanilla ETFs. However, AHAM’s management fee for its L&I ETFs is only about 1% per annum — about the same imposed on local plain vanilla ETFs, says Chong Lee Choo, director of AHAM’s Innovation Lab and alternative investments.

Investors can buy and sell units throughout the trading day like any other publicly traded shares, with a minimum board lot size of 100 units. The TradePlus NYSE FANG+ Daily (2x) Leveraged Tracker and TradePlus NYSE FANG+ Daily (-1x) Inverse Tracker have an initial issue price of RM4 per unit while the TradePlus HSCEI Daily (2x) Leveraged Tracker and TradePlus HSCEI Daily (-1x) Inverse Tracker have an initial issue price of RM2 per unit.


Volatility welcomed

To introduce these funds to the Malaysian market, AHAM worked with its investment adviser Samsung Asset Management (HK) Ltd, a wholly-owned subsidiary of Samsung Asset Management Co Ltd.

Samsung Asset Management Co Ltd is a leading asset management firm in South Korea, with more than US$208 billion under management. It was the first to introduce L&I and futures-based ETFs in South Korea in 2009 and Hong Kong in 2016.

The two indices — NYSE FANG+ and Hang Seng China Enterprises Index — were chosen by AHAM as they experience high volatility and are secular in terms of trends, says Teng. “We chose the indices because they are more volatile and attractive to global investors. If the volatility is not there, investors are not keen to trade because they do not have the ability to trade in and out of those instruments.

“Volatility is not something long-term active portfolio managers enjoy seeing, but it is definitely welcomed for shorter-term daily trading tools. While we believe in the longer-term outlook and growth potential of the sectors and markets that these indices represent, comparatively bigger swings from the indices provide investors with an opportunity to capitalise on the larger movements of the indices over the shorter term.”

The Hang Seng China Enterprises Index tracks 50 of the largest and most liquid Mainland China stocks listed on the Stock Exchange of Hong Kong. The index provides access to global names such as insurance giant Ping An Insurance, tech giant Tencent Holdings and some of the world’s largest banks, like China Construction Bank, Bank of China and Industrial and Commercial Bank of China.

“The insurance business is growing quite well in China, although the penetration rate remains low compared with other markets. I always tell people not to measure by penetration rate because the population is 1.4 billion. It will take many years for them to achieve the level that Malaysia has,” says Teng.

“Nevertheless, China is a huge market and I think companies such as Ping An have invested a lot in technologies that will enable them to penetrate the market much faster than traditional insurance players. Apart from the new economy players, the index also consists of old economy players such as telecommunications company China Mobile and oil and gas company Sinopec Corp.”

Will the ongoing protests in Hong Kong affect these companies, given that the Hang Seng China Enterprises Index is a stock market index of the Stock Exchange of Hong Kong?

Not necessarily, says Teng. “For a lot of these companies, the revenue derived from Hong Kong is very little. While the listing is in Hong Kong, the actual operations are mainly in China. So, whatever happens in Hong Kong has very little impact on their business.”

Having said that, the Hang Seng China Enterprises Index is one of the indices that have been affected by the ongoing protests and other secular factors. This means investors have the opportunity to capitalise on the movements of the index using instruments such as L&I ETFs.

Meanwhile, the NYSE FANG+ Index tracks the performance of the top innovators across the global tech industry through equal weighted holdings in 10 highly liquid names. The term FANG was coined in 2013 as an acronym for Facebook, Apple, Netflix and Google (now Alphabet). The other companies in the index are Amazon, Alibaba, Baidu, Nvidia, Tesla and Twitter.

“Each of these companies has a different cycle. Apple, for example, is enjoying an all-time-high share price due to the continued demand for its newly launched devices. Nvidia is currently one of the leaders in manufacturing chips used to power artificial intelligence. Amazon and Alibaba are some of the largest e-commerce and cloud services companies in the world,” says Teng.

“We think it is a good mixture of companies with very strong free cash flows. I think the only company that is not having strong free cash flow is Tesla, but it is in the index because of the amazing development of its car technology. That is essentially our thought process when deciding on the underlying index.”

The NYSE FANG+ Index has seen some volatility due to the US-China trade negotiations. Even a single tweet from US President Donald Trump may affect the index, providing an opportunity for investors to take either a positive position through the TradePlus NYSE FANG+ Daily (2x) Leveraged Tracker or a negative one through the TradePlus NYSE FANG+ Daily (-1x) Inverse Tracker, says Teng.

“Either way, there is a tool to capitalise on the markets, regardless of the direction they move in. If clients think we are headed for a recession, for example, they can buy into the inverse ETF. They will be able to participate, even in the downside of the economic cycle,” he adds.

Having said that, Teng does not think the global economy will see a recession in the next 12 months. “My sense is that we are still going through a very slow growth environment globally. I think the central banks are doing a lot to cushion the economy with more accommodative monetary policies,” he says.

“What we have seen in the last decade is that each time the central banks start to react and reduce interest rates, the economy does respond, albeit not immediately. It may take about seven months before we can see the effects in the economy.

“Will this round be different than the last? If history is a guide, then by the middle of next year, in the second or third quarter, we should see the economy stabilise or experience a soft landing, arising from the reduction in interest rates.”

 However, the US-China trade tensions remain an ongoing concern. AHAM’s house view is that the two parties will find an interim solution and the tensions will not escalate further. “We have seen one of the worst periods of the trade tensions. We think they will dial down the tensions as we go into 2020, partly because the US has seen how the tit for tat affects the economies. Next year is the US presidential election. I think anyone seeking election would like to have a decent economic cycle,” says Teng.

“It has also become clear to China that the trade tensions have impacted their economy as well. So, I think they also understand the need to reduce the pressure. We think the economic giants can come to a landing on the interim solution.”

While investors may not be exposed to stock risks with L&I ETFs, as the indices they track consist of big companies with easily accessible information, there are many other risks that investors should bear in mind before using these instruments.

One of them is long-term investment holding risk, says Chong. The strategies aim to provide returns based on daily targets. So, the compounding effects can become more apparent over the long term. “Let’s say an investor holds the investment for a week. If by the end of the week, the market ends at the same level it started, the investor may lose money due to rebalancing effects,” she points out.

Another is the trading hour difference risk. As the NYSE FANG+ Index tracks companies listed on the US market, investors may not see major movements during Bursa’s trading hours. Instead, these will take place while they are sleeping.

“We have suggestions on how to address this risk. Let’s say they take a long position on the TradePlus NYSE FANG+ Daily (2x) Leveraged Tracker. At night, if the market is going down and they are still awake, they can actually correct their position. With a US trading account, they can buy an inverse instrument immediately and hedge their positions. That is one of the risk management strategies that they can use,” says Chong.


Spurring local ETF market

The Malaysian ETF market is considered small when compared with those in Singapore, Japan, Taiwan and Hong Kong. Including AHAM’s four new ETFs, the local market has only 15 ETFs.

Teng thinks it is an issue of demand, which is still low in the country. “I think industry players have been trying to educate the public by introducing more ETFs in the market. The other players who came into the market before me found that demand was generally weak and institutional funds were not using ETFs as their building blocks. They still very much invest through portfolio managers on an active basis. By comparison, if you look at the US where ETFs were first developed, the market has grown by leaps and bounds, partly because it has been taking market share from active managers,” he says.

“We think the development of ETFs has to be anchored by institutions that can be supportive of all the initiatives. We are still going through the process of engaging some of these institutions to participate in the market through ETFs. We have talked to a number of them and have taken in the suggestions they have given. We hope to move in sync with their thought process regarding the development of ETFs here.”

He adds that one of the biggest issues raised by these players is cost. ETFs in Malaysia are more costly than those in the US. “Again, this is part and parcel of the development process for the local ETF industry. Of course, the US developers can continue to lower the cost because they have the skills and size. Eventually, if and when we have the size, we can also match their fees. But before we can have that, we need people to participate. It is a chicken-and-egg situation.”

Describing these challenges as growing pains, Teng says AHAM has been playing a more active role to promote the awareness of ETFs. The firm has been organising roadshows across the country and working with other entities such as Bursa and other brokers to educate the public on matters relating to ETFs.

Teng says the firm is prepared to invest to increase awareness among market participants. “Businesses are not built in a day. If education is what is needed, let’s invest in it. We are in for the long haul. I told my team members, ‘Let’s put in the effort and not be discouraged just because the volume is not there. As long as we are on the right path in terms of introducing products and building our own distribution channel, we will get our breakthrough eventually’.”

Prior to this, AHAM already had two ETFs in its portfolio — the TradePlus Shariah Gold Tracker, which it listed in late 2017, and the TradePlus S&P New China Tracker, which it listed on Jan 28. According to Bloomberg data, the former had provided a return of 13.14% as at Nov 26 while the latter had seen a return of 8.1% as at Oct 31.

Being the first to launch L&I ETFs in the domestic market, the firm is not sure how investors will react to the products, says Teng. However, he anticipates some excitement in the market, if the volume of warrants is any indication.

“We foresee that these strategies could be taken up by traders with a slightly lower risk appetite than warrant traders, given the lower leverage ratio. Alternatively, warrant traders could use these strategies to manage risks in periods where they are less confident of the direction of the underlying index, but still want amplified exposure,” says Teng.

“We believe that local investors are ready for more and these ETFs will give them exposure to what is already a popular strategy in the more developed markets.”