China’s ETF market is poised to experience robust growth over the next year, according to research from ETF custodian and administrator Brown Brothers Harriman (BBH).
Chris Pigott, Senior Vice President, BBH Hong Kong.
According to the firm’s second annual survey of 100 professional investors in the Greater China region, nearly two-thirds (63%) of respondents plan to increase their ETF allocations in the next year.
When looking solely at Mainland China, that number jumps to 77%, up from 43% in BBH’s 2018 survey.
The report also found that the level of ETF usage amongst current ETF investors in Greater China is relatively low compared to global markets.
Only 7% of investors surveyed have over 50% of their assets under management in ETFs, compared with 13% for Europe and the US combined. According to BBH, while this is a testament to the greater size and liquidity levels in European and US markets, it’s also an indicator of room for growth in Greater China.
Chris Pigott, Senior Vice President, BBH Hong Kong, commented, “ETFs are becoming an increasingly important component of institutional investors’ portfolios across the region. Looking forward, regulatory development and enhanced ETF market infrastructure are areas of focus that will provide the foundation to support the expected growth.”
Cost not a key driver in ETF selection
Defying global industry assumptions that cost is a key factor for investors when selecting ETFs, expense ratio ranks near the bottom of the list of selection criteria in Mainland China and Taiwan.
Instead, historical performance and ETF issuer are top of mind. Historical performance is cited as the most important selection criteria for investors in Hong Kong and Taiwan, a sentiment shared by US and European investors, while the top drivers for ETF selection in Mainland China are ETF issuer and index methodology.
“As ETF adoption by retail investors in Greater China is still at a nascent stage, perhaps investor sensitivity to fees is less acute than in other regions,” said Pigott. “When compared with regional mutual funds, ETFs on the higher end of the expense ratio – such as active or smart beta ETFs – still often present a significant cost value.”
Hong Kong, however, is more in line with the US and European markets, where expense ratio is a key criterion, especially for institutional investors. According to BBH, this trend highlights the exposure of Hong Kong investors to overseas markets and their consideration of a broad set of factors when making investment decisions.
Smart beta ETFs catching assets from mutual funds
Smart beta ETFs are proving to be very popular in Greater China with 97% of respondents having at least one smart beta ETF in their portfolio. That number is 94% in Europe and 92% in the US.
Additionally, 38% of respondents across Greater China expect to increase their exposure to smart beta products in the next year. This demand is led by investors from Taiwan and Mainland China where 45% and 40% of respondents, respectively, expect to increase their allocations to smart beta.
In a blow to the mutual fund industry, the research found that over one-third (38%) of those surveyed purchased a smart beta ETF in the last 12 months in order to replace an actively managed mutual fund.
Taiwan investors are leading the way with 65% of respondents having reallocated from active mutual funds to smart beta ETFs in the past year. However, BBH believes future growth in this space is likely to come from Mainland investors.
Pigott said, “In Mainland China, a market historically dominated by active mutual funds, the ongoing regulatory reforms focusing on deleveraging the financial markets and reallocating investment from wealth management products into more transparent collective investment vehicles, should be a tailwind increasing the use of ETFs, including smart beta.”
Mainland investors keen to access Hong Kong ETFs
An overwhelming majority (98%) of Mainland China respondents are interested in buying Hong Kong ETFs either through the Stock Connect or Mutual Recognition of Funds (MRF) program.
The inclusion of ETFs into the Stock Connect, however, has faced delays due to issues normalizing the settlement infrastructure between the respective exchanges. As a result, regulators have begun to review alternative options for mutual market access for ETFs, including cross-listing ETFs through the existing MRF program that is already in place for mutual funds.
When asking Mainland investors about their preference for accessing Hong Kong-listed ETFs in the future, half of the respondents said they would buy ETFs that are cross-listed on the Shanghai Stock Exchange. Meanwhile, 40% said they would buy Hong Kong ETFs through the Stock Connect program.
BBH warns, however, that cross-listing will potentially bring added complexity and cost to ETF issuers dependent on how the Mainland listing is facilitated.
Potential headwinds facing ETFs
Regarding fixed income ETFs, liquidity and tracking error are the main concerns for investors in Greater China. Liquidity was the top response for Mainland investors (45%), which BBH believes highlights the liquidity challenges resulting from corporate bond defaults in the China bond market.
The main challenges facing ETF growth in the future, however, are ease of access and trading cost with 31% of respondents in Greater China stating that the platforms they use make ETF trading difficult or expensive.
While platform issues could be a potential headwind in further ETF adoption, BBH notes this may provide an opportunity for global intermediaries to improve the user experience and make trading ETFs more cost-effective.