Rapid growth of the Asia Pacific exchange-traded funds (ETF) market has given rise to the need for algorithmic trading tools that enable institutional investors to access the ETF market efficiently and enhance the liquidity of these instruments.
Herman Chen, head of Lyxor ETF distribution for the Asia Pacific region, Lyxor Asset Management, noted a trend – which he sees as a key driver of the demand for ETFs among institutional investors in the region – whereby institutional investors in Asia who had previously outsourced the portfolio management function to third-party managers now prefer to manage the funds in-house. “In order to do that, they need very robust IT systems, a strong market research team and a portfolio management team. But in Asia at the moment, institutional investors don't have sufficient resources to enable them to make the investment directly. That's why given ETFs' transparency, liquidity, cost efficiency and ease of settlement, they are one of the preferred investment tools for institutional investors,” he added.
Asia Pacific (ex-Japan) ETF assets under management (AUM) have doubled from US$27 billion in 2007 to US$53.3 billion in 2010 (4% of global ETF assets), and further to US$56.9 billion at the end of Q1, according to BlackRock's ”ETF Landscape Industry Highlights'.
BlackRock expects global AUM in ETFs and exchange traded products (ETPs) to increase 20-30% annually over the next three years, taking the global ETF/ETP industry to approximately US$2 trillion in AUM by early 2012. Separately, ETFs' AUM should reach US$2 trillion globally by end-2012, from US$1,367.4 billion at the end of February 2011. However, the global ETF market is still accounts for less than 10% of global AUM that is predominantly invested in mutual funds, but market participants see huge potential due to the disproportion between the passive and active shares of AUM.
One challenge faced by ETF providers has been to get Asian institutional investors to trade Asia-listed ETFs as opposed to trading them in the US and Europe. Algorithmic trading tools designed specifically for ETFs will help to enhance the liquidity of these instruments in Asia. “The arbitrage should be taking place all the time whenever there's a premium or discount of the fund to the NAV. Only authorised participants can take arbitrage, and the incentive for the authorised participants (APs) to undertake arbitrage needs to be calculated carefully, and that's where robust electronic trading programs can capture the arbitrage opportunity efficiently,” Chen added.
An AP is an institution chosen by an ETF sponsor to undertake the responsibility of obtaining the underlying assets needed to create an ETF. After acquiring all the underlying stocks that will form the ETF, the AP will often need to transfer the shares to a custodian bank.
A key difference between a conventional algorithmic trading program and one designed for ETFs has to do with the fact that the liquidity of an ETF isn't entirely measured by on-screen trading volumes. “One of the challenges facing institutional investors is that if one wants to put, say, a US$100 million order into an ETF with relatively few assets under management and daily trading volume on the screen on the secondary market, the trade would normally not get executed in the secondary market. However, we as the ETF provider and other APs will be able to help them with the underlying asset liquidity to fulfil the investment order in the primary market,” Chen noted.
Author: Jill Wong