Although the Asian exchange-traded fund market is still in its infancy, a number of forces are building to bring it to a tipping point that will result in accelerated growth rates, according to a report by Deutsche Bank.
Increased coordination among regulators in Asia, a larger range of ETF products and increased use of beta index products are some of the factors which will propel Asia’s ETF market growth in the next year.
Physical replication and synthetic replication are two of the most common structures used in the construction of ETFs. Physically replicated ETFs buy all or a representative portion of the underlying securities in the index that they track. In contrast, ETFs employing synthetic replication use a basket of collateral securities, which bear no resemblance to a fund’s index’s constituents, and a total return swap, as part of their investment holdings.
Most of the US ETFs use physical replication, while European ETFs use both physical and synthetic replication.
Deutsche Bank conducted a study comparing the performance of both US and European domiciled ETFs tracking Asian benchmarks. It found that synthetic ETFs tracked their benchmark better than physically replicated ETFs for all of the indices examined.
The tracking difference is especially apparent for physical replication of broad indices, such as the MSCI Emerging Markets, for which optimised baskets are used. Optimisation entails sampling techniques to physically replicate an index, often leading to a basket that might include significantly fewer constituents, thus introducing a major source of tracking error. Unlike physically replicated ETFs which face such practical replication challenges, the performance of synthetic ETFs is not impacted by the sampling issue.
In addition to the tracking difference, Deutsche Bank has observed that European and US ETFs have different tax implications when it comes to dividend treatment. European domiciled ETFs are generally more tax efficient for Asian investors as dividends of US domiciled ETFs are taxable in the US.
As the US ETF market is larger, and often more competitive, than the European market, Deutsche Bank has observed that ETF bid/ask spreads tend to be tighter in the US. Therefore, in the short term holding US domiciled ETFs is more cost effective. In the long term however, for those ETFs that have larger tracking errors associated to them, European domiciled ETFs might prove to be more effective, since US ETFs use physical replication which have higher levels of tracking error associated with its holding.