Where the ETF market is heading

From ASX

The ASX Listed Exchange Traded Funds market is growing rapidly, with combined market capitalisation of ETFs rising 39.4 per cent to $4.76 billion over the year to April 2011.

ETF listings have grown from 31 to 45 over that period and different product styles have been launched, including "rules-based" ETFs providing higher yield; currency ETFs; and synthetic or "swap-based" ETFs where the ETF does not necessary hold the same assets as the index it tracks, and where the issuer may have a "swap agreement" with a derivative counterparty to exchange the difference in performance between assets held by the ETF and the performance of the index.

More ETFs are expected to list on ASX as Australia follows the global trend of a vast array of ETFs being launched.

As US and European ETF markets have boomed, global regulators have considered the role of ETFs in market volatility events, such as the May 2010 "flash crash" in the United States, when the S&P 500 futures contracts and S&P 500 ETF fell by 5 per cent in five minutes. The Australian Securities and Investments Commission (ASIC), the Reserve Bank of Australia and ASX have reviewed key issues in the Australian ETF market.

ASX Investor Update asked Richard Murphy, ASX's General Manager, Equity Markets, (pictured) about growth in the Australian ETF market and what investors can expect in the next few years.

ASX Investor Update: Richard, why is the Australian ETF market growing so strongly?

Richard Murphy: ETFs have been listed on ASX for 10 years but it is in the past few years that growth has accelerated. They have become more popular with long-term investors who are happy with a market or index-like return, and prefer paying lower fees and having the transparency that comes with using listed products on a well-regulated exchange, such as ASX. More traders are using ETFs to capitalise on short-term market movements. More financial advisers are starting to recommend ETFs and more are expected to do as "trailing" commissions are banned from July next year. ASX is also seeing institutional investors showing stronger interest in ETFs - an important development given overseas ETFs markets are dominated by professional investors, whereas in Australia they are dominated by retail investors.

ASX Investor Update: Richard, what will the ASX ETF market look like in the next three to five years?

Richard Murphy: I expect continued strong growth in ETFs over that period. There could be more than 100 ETFs listed, from a dozen or so issuers. There will be new ETFs over fixed interest, more commodity ETFs, and leveraged or "inverse" ETFs that provided geared exposure or let investors take a view on a falling market or sector.

ASX Investor Update: Does rapid growth in global ETF markets present risks for investors?

Richard Murphy: If left unchecked, there could be risks from more exotic ETFs that use gearing or leverage heavily or are based on complex derivatives contracts. Over time, more swap-based or synthetic ETFs that introduce counterparty risk through the use of derivatives contracts will list on ASX. [Counterparty risk is the risk of another party to the transaction not fulfilling its obligations]. It is worth remembering that synthetic-based ETFs may offer potential benefits, such as lower fees and the elimination of tracking error [a return that deviates positively or negatively from the return from the underlying index] compared to standard ETFs. The challenge is ensuring there is appropriate regulation for all the innovation expected under this broad banner of "exchange traded funds".

ASX Investor Update: How is ASX addressing potential counterparty risk in synthetic ETFs?

Richard Murphy: Firstly, ASX and ASIC have worked closely together on this issue. ASX expects the rules it has developed for synthetic ETFs to be formally updated in ASX Listing Rules this year. Simply put, there are two key rules. The first limits the amount of an ETF that can be exposed to counterparty risk; no more than 10 per cent of the ETF's net asset value can be "swapped" out using derivative contracts. Second, all derivative counterparties for synthetic ETFs listed on ASX are limited to bank Authorised Deposit-taking Institutions or foreign banks that meet ASX requirements in this regard. We believe these rules put ASX at the forefront of global ETF regulation.

(Editor's note: Synthetic Exchange Traded Funds explain the features, benefits and risks of these ETFs and how ASX has put measures in place to limit counterparty risk.)

ASX Investor Update: Should investors be concerned about potential risks from synthetic ETFs?

Richard Murphy: It is more of an education issue - something to be aware of. But the reality is, nearly all ETFs currently listed on ASX are common physical-backed ETFs that own the assets to which they offer exposure, and do not use derivatives contracts in any substantial way. The vast majority of retail investors, who use ETFs for exposure to local or international markets or sectors, are expected to use more common or basic ETFs. Those who chose synthetic-based ETF can do so knowing their issuers must meet important requirements before these products can list.

(Editor's note: Investors can identify synthetic ETFs by looking at the ETF name, for example S&P/ASX 200 Resources Sector Synthetic ETF.)

ASX Investor Update: Richard, what advice would you give investors considering the ETF market for the first time?

Richard Murphy: As with any investment product, do your homework. Do not assume all ETFs are the same. Understand that there will be many different types of ETFs - with different risk profiles - launched on ASX over the next few years, to appeal to different types of investors, including fund managers and financial advisers.

Know that some ETFs may suit more sophisticated investors comfortable with gearing and the use of derivatives-based ETFs, while other physical-backed ETFs may be more appropriate for retail investors who want long-term index exposure through ETFs. There will be a lot more ETFs to choose from, which is a good thing for investors, but with that comes the need to know the main ETF differences and risk profiles.

ASX Investor Update: What is ASX doing to educate investors on ETFs?

Richard Murphy: ASX recently launched a free online course on ETFs and exchange traded commodities that provides a good introduction to ETF investing. ASX continues to run free events, such as ASX Investor Roadshows, to highlight the features, benefits and risks of using ETFs in different investment strategies. And there is plenty of information on the ASX website about the range of ASX Listed ETFs. Another positive development is more specialist ETF research being produced in Australia, which will give financial advisers and stockbrokers a stronger basis on which to recommend and monitor ASX Listed ETFs.