Access-starved HK should be eager for ETF Connect

The average Hong Kong investor will welcome news that ETF (ExchangeTraded Fund) Connect will launch in the second half of this year. Hong Kong’s fledgling ETF market needs the boost this cross-boundary trading scheme will provide, giving local investors easier access to the Chinese mainland ETF market.

The drumbeat march of ETF investments — low-fee listed securities that passively track a basket of stocks — is growing louder and louder and there seems little that active fund managers can do about it. Investment research firm Morningstar says active management saw outflows of $207.5 billion from United States equity active funds last year — deemed a “relative victory” compared with previous years — while investors placed $220.4 billion in US equity passive funds. Overall, a record of almost $700 billion went into passive products, the sixth year in a row that inflows have risen.

It is not hard to see why. Jack Bogle devised the first low-cost index fund in 1976, tracking the S&P 500 Index — a bet that the Wall Street titans could not routinely beat the humble index fund, net of fees. The industry laughed at Bogle but, as history demonstrates, they are not laughing anymore. Only 7 percent of US largecap mutual funds, for example, could beat the S&P 500 over the 15 years up to June last year.

Why do fees matter? Well, they certainly add up, compounding along with your investment returns. For example, if you invested HK$100,000, with earnings of 6 percent per annum, you would have HK$430,000 after 25 years. But if you allow for 2 percent a year in fees — an approximate average for active management — you would end up with only HK$260,000 — an eye-watering 40 percent off the final value of your account.

The pressure active managers have felt recently is just the start of the trend. Investors of all stripes — from pension funds to momand-pop retail investors — increasingly scrutinize fees and there seems little the likes of Wall Street can do that passive investments cannot do cheaper and, more often than not, better.

What, then, explains why demand for passive investing and its most popular vehicle, the ETF, remains largely flat in Hong Kong? In fact, the trajectory is not flat, but downward; in the first three quarters of last year, for example, $4.8 billion was pulled out of Hong Kong’s ETF market, compared to a $38.3-billion rise in the Asia-Pacific region as a whole. This trend has continued for several years.

In 1999 the city became the second market in Asia to launch ETFs but since then investment activity has largely remained in just a small number of the 100 or so ETF products accessible locally. The limited number of attractive products available to investors does not help, although offering a wider variety is only part of the solution, alongside better education and, perhaps most pertinently, an improved regulatory environment.

ETF popularity surged in the US, for example, after active managers were required to provide a fee-based payment model, rather than rely on commissions (that is, incentives) from fund managers.

Despite the obvious advantage to investors Hong Kong has not taken up this model and, with ETFs not paying commissions, financial advisers continue to be incentivized to sell active funds, which do. ETFs moreover evoke mediocre enthusiasm from pension fund managers — a potentially huge source of new capital for Hong Kong-traded ETFs — with only a limited number of such products approved for pension scheme use.

These disadvantages imposed on local investors have led them to make better use of ETFs trading in the US and Europe. The average daily turnover of ETFs in Hong Kong last year was $4.3 billion, far smaller than other developed economies in the region such as Japan. Persuading more international fund managers to cross-list more popular funds may go some way to encouraging ETF trading in Hong Kong.

The fundamentals of an effective investment strategy for the average investor in Hong Kong and beyond remains the same as when Bogle first came on to the scene: purchase a mixture of a few broad, low-fee equity and bond funds, stay invested for the long term, do not trade too often and do not panic over the daily vicissitudes of the stock market.

If local authorities want to truly offer this simple strategy to investors in Hong Kong, they need to take many further steps to help provide the right environment for it to flourish. ETF Connect should be the first of many.