Friday 29 Mar 2024
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This article first appeared in Personal Wealth, The Edge Malaysia Weekly, on March 7 - 13, 2016.

 

In volatile times like these, exchange-traded funds could play a bigger role in an investor’s portfolio. With some knowledge of macroeconomics and technical analysis, investors could trade in ETFs to generate a higher return. 

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Liquidity issue

The lack of liquidity when it comes to investing and trading in ETFs has always been seen as a challenge for investors. Only 54.15 million units of ETFs worth RM59.15 million changed hands in 2014, according to Bursa Malaysia. And only 7.86 million units of ETFs worth RM9.96 million were traded in the first half of last year. 

Bursa Malaysia said last year that the “FBM KLCI’s single-day trading volume of about two billion shares easily surpasses the ETFs’ total volume traded in a year”. Heavyweights such as Malayan Banking Bhd see an average daily trading volume of about 10 million shares. 

This is one of the points cited by active fund managers who explain why ETFs have not taken off in the past 10 years, as the price of ETFs will not gain momentum without liquidity. 

While acknowledging the lack of liquidity in the open market is why ETFs have not taken off in Malaysia, Mahdzir says you should not compare the trading volume of an ETF with that of individual stocks. “While ETFs are traded like shares, the underlying structure is a unit trust structure,” he points out.

He also says the price of ETF shares on the open market will always be in line with the net asset value of the shares. This is because the market maker, which is sitting behind the open market to provide liquidity for the ETFs, will always make an arbitrage on the ETF shares when the share price deviates away from the underlying net asset value.

“That is why individual investors should not see liquidity as a risk to their investment. The market makers are always there to provide [bid and offer] prices close to the prevailing NAV of the ETF and provide the liquidity. It is a misconception that ETF share prices will collapse because of illiquidity,” says Mahdzir.

A market maker plays an important role in facilitating the transactions of an ETF, between the buyers and sellers of ETF shares. They are usually investment banks and securities companies. 

A market maker sources for the securities based on the perfect basket of underlying shares that mirror an index advised by the fund manager (who designs, introduces and oversees the ETF) and delivers a basket of underlying securities to the fund manager (through the custodian bank). The market maker in turn receives one creation unit issued by the fund manager (through the custodian bank as well).

A creation unit is typically a large block of ETF shares (a minimum of 400,000 shares). Upon receiving the creation unit, the market maker can choose to hold on to the units or sell some or all of them on the open market based on the mark-to-market price of the net asset value. This is called the creation process.

However, the market maker can also go through a redemption process, which is the reverse of the creation process. This means the market maker purchases ETF shares on the open market, forms a creation unit and delivers it to the fund manager. The market maker then receives individual securities (which form the creation unit) to the exact net asset value of the creation unit. They can be kept or sold on the open market.

The creation and redemption processes are important mechanisms to make sure the price of the ETF shares is always in line with the net asset value of the ETF. That is because when the price of the ETF shares goes higher or lower than its net asset value, the market maker will execute an arbitrage and earn a risk-free profit.

To provide liquidity, the market maker will come up with a bid and ask price on the open market and there is “no liquidity issue” for an individual investors to trade in ETF shares even though the trading volume on the open market remains low. 

“An ETF share can be bought and sold by the market maker with a slight spread of about 0.5% of the net asset value,” says Mahdzir. 

“Why is it that you can buy into a unit trust fund without asking about liquidity, but are so worried about liquidity when you buy into an ETF? The sales charge for unit trust funds is about 5% and the spread [of the ETF share price and net asset value] to buy into an ETF is only about 0.5%.” 

ETFs do not impose a sales charge on investors and the management fee is lower than 1%.

Last year, i-VCAP came out with three ETF products to offer more options to the market and to create more depth and awareness of the ETF sector. There are more ETF products in its pipeline, including products with a regional focus and sector focus, depending on market demand. 

“The awareness now, compared with four years ago when I came on board, has actually increased and we do get a lot of interest, though not as much as we would like. Now, the challenge is to convert the awareness of the product into actual trading,” says Mahdzir. 

 

Challenges faced by ETFs

Maznah says she does not see AmInvest launching any new ETF products in the near future. “There isn’t a compelling business reason [for us to launch new ETFs]. We positioned ourselves as an early bird because you never know when such trends pick up. We launched the first two and that would be it for now.”

But why haven’t ETFs taken off in Malaysia despite a much lower fee compared with unit trust funds and giving investors easier access to markets around the world?

Maznah says it is partly because the most active funds in Malaysia and emerging markets have continued to beat the market, which it benchmarks against, owing to market inefficiencies. This is unlike the stock markets in developed countries such as the US, where the markets are efficient and active fund managers strive hard to outperform them.

“For instance, the KLCI was down about 3% and many active fund managers happily beat that. For example, the return for our AmMalaysia Equity fund last year was 12.23%. And it’s not only us, many funds out there in Asia have performed well too. So, why should investors look into plain vanilla ETFs?” she says.

An industry player who does not wish to be named has a different view on why ETFs have not taken off locally despite providing investors with broader investment options. “One of the reasons ETFs have not taken off is partly because the fees for them to be listed on the stock exchange are high, and the only stream of revenue for the fund manager is the management fee, which ranges from 0.5% to 0.7% per annum. It is a good product for the public, but it is not viable unless it gets the size and volume. 

“An ETF provider is required to appoint an adviser and lawyer, for instance, to get its product listed on the stock exchange. It could be much more expensive to launch compared with a unit trust fund. And this has not taken into account the cost of marketing and promoting the product.” 

More regulatory incentives should be given to encourage ETF providers and market makers to launch more ETFs, the industry player adds.

Another reason ETFs have not taken off locally is that there is no incentive for intermediaries such as agents and financial planners to push the products in the market. “Unit trust agents and financial planners push products because of the commissions they get. Of course, they hope the products can attract a good return for them,” says Mahdzir.

This, he points out, compares with the developed market, where regulators have got rid of the commission-based structure and replaced it with a fee-based structure. Thus, financial planners in the developed market tend to promote funds and investment products that have the least cost to their clients. 

Maznah says, “Nobody will sell ETFs even if they offers 0% fee for investors and are the best products in the world because the intermediaries get no incentive for selling them. This is the same even in the UK, which is seen as an international financial centre. It was only recently that ETFs took off in the UK because its regulators changed the regulations on retrocession fees to distributors.”

However, she remains positive about the future of ETFs as they have taken the world by storm, especially in the developed markets that have done away with the commission-based structure on all products, including unit trust funds. 

“Looking at the trend in the world, ETFs are more likely to take off if they are supported by a change in regulations. This happened in the US and the UK. Even Australia and some countries in Europe have followed suit. It is still not happening in Malaysia and most of Asia. But once the regulations are changed, they could take off in very big way,” says Maznah.

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