Proactive Steps to Passive Trading in Asia

Singapore is a relatively small city-state in Asia that hosts some 5.7 million people. The island almost fits into New Zealand’s Lake Taupo, save about 100 kilometers.

For all the talk about Singapore being an emerging market, the market capitalization of the island’s leading exchange—the Singapore Exchange (SGX)—is only $637.3 billion, according to the latest monthly statistics from the exchange. (All currency amounts have been converted to US dollars.) Comparatively, from a market capitalization perspective, SGX’s peers in the Asia-Pacific region dwarf it. At the end of November, the market capitalization of the Hong Kong Stock Exchange stood at $3.3 trillion, while the Australian Securities Exchange was at $1.2 trillion. 

To put that into perspective, according to data recorded by agency broker ITG, demand for liquidity of a $100 million market-level portfolio takes up about 16.7 percent of a 21-day median daily volume. ITG used the indices of different countries such as the Straits Times Index, S&P/ASX 200, Topix, and the Hang Seng Composite Index, to calculate the impact on liquidity and cost of investing a $100 million portfolio in those indices. According to the data recorded by the execution broker, in comparison, the same portfolio amounts to only 3.6 percent of the HSCI, and 3.1 percent of the ASX 200. 

Even as the SGX has struggled to grow, it has established itself as an innovative exchange. This seems to be one of the first few points about the company that comes up in conversations among many industry participants.

But the SGX sees a path toward growth—passive investment. The question is whether the exchange operator will be able to differentiate itself as it tries to draw new investment into Singapore. 

“There is value proposition from the Hong Kong/Singapore perspective looking at attracting local players, so it’s a good strategic move from the SGX. It is a complex business and that’s probably why they are working together with S&P. They need to have scale and with the S&P partnership, that’s probably a sensible route to market.” Julie Kerr, EY

The Passive Wave

After investing heavily in its trading platform—including, most recently, partnerships with IPC and MilleniumIT and creating a market data and connectivity unit—the SGX has looked to entice new forms of investment. Just over a year ago, the SGX launched its index business, SGX Index Edge, which has two distinct segments, says Simon Karaban, head of index services for SGX. One is its role as a custom calculation agent for structured product managers and the other is for building SGX-branded indices. 

Since starting, it is now calculating indices for about 100 clients and has also launched its first bespoke index, the SGX APAC Dividend Leaders REIT Index, with the aim of bringing quite a few more indices to market in 2017, Karaban adds.

Although the passive investment market has been growing rapidly in Europe and the US, it is still relatively small in Asia, where investors still lean more toward actively-managed investment strategies. According to data compiled by etfgi.com, assets invested in exchange-traded funds and products (ETFs and ETPs) listed in the US reached $2.5 trillion as of December, $556 billion in Europe as of December, and $132 billion in Asia-Pacific, excluding Japan, as of October, its most recent number. But the passive space in Asia—and particularly in Singapore—is gaining traction. For example, in the past year alone, ETF volumes grew 256 percent year-on-year from 15 million shares in November 2015 to 53 million shares traded a year later on the SGX, according to the exchange. Year-on-year value for ETFs was 193 percent higher in November 2016 at $320 million from a year ago. This growth, though, comes with its own technological challenges. Specifically, says Lea Carty, global head of buy-side solutions for Bloomberg, these are the proliferation of data and the need for new analytic models and capabilities.

“This hampers a common understanding of basic investment concepts associated with passive strategies such as risk and performance,” he explains. 

One example is back-testing, which is commonly done when developing an index. This requires several components, including—but not limited to—full point-in-time data for all the instruments the strategy may invest in, construction and optimization capabilities to implement the strategy, and a platform to carry out the back-test. Bloomberg has built out its capabilities to provide data, portfolio construction and optimization and factor modeling, as well as its ability to help firms to develop and replicate smart-beta concepts to meet client demand, says Carty.

Factor Growth

The SGX launched its first bespoke index in August. In October, fund creator Phillip Capital listed its own ETF benchmarked against the SGX APAC Dividend Leaders REIT Index, making it the first physically replicated REIT ETF listed on the exchange. It is a dividend-weighted index capturing more than 70 percent of the region’s REITs by total capitalization accounting for size, free-float methodology and liquidity. The ETF is expected to pay between 4 to 5 percent in dividend yield per annum. 

But this is only the start for the SGX, as it will look to launch more bespoke indices in the near future, according to Karaban. In the first half of 2017 the company will bring to market a handful of factor-based indices. To do this, it will leverage its recent partnership with S&P’s Global Market Intelligence’s Alpha Factor Library. The partnership will also be used to develop new quantitative index models and smart beta indices across the Asia-Pacific region.

SGX Index Edge now has access to comprehensive research and datasets available through Factor Library that will allow it to identify sources of alpha as well as enhance its own existing index research and design capabilities. This opens up opportunities for it to also develop further customization of index offerings for issuers, asset managers and investors across Asia.   

“SGX has a great history, a strong technology platform, great operational infrastructure and governance framework,” says John McCareins, managing director of APAC at Northern Trust Asset Management. “As a leading exchange in Asia, the SGX is going to gain attention in launching this suite of indices.”

While gaining attention is great, the SGX will still have to differentiate its offering from other index service providers. This, McCareins says, will come down to the methodology used to create these indices, and whether or not the SGX has partnerships that enable it to tap into the intellectual property of other investment houses or research services. 

“The thematic approaches and strategies are all areas you have to consider in whether you can launch the index and the applicability and adoption rate among potential investors,” he says.

Julie Kerr, Asia-Pacific ETF leader at consultancy EY, says SGX’s expansion in the indices business should give it a competitive edge. “There is value proposition from the Hong Kong/Singapore perspective looking at attracting local players, so it’s a good strategic move from the SGX,” she says. “It is a complex business and that’s probably why they are working together with S&P. They need to have scale and with the S&P partnership, that’s probably a sensible route to market.”

Passively Hungry 

Compared to the US and Europe, Asia is only just now gaining traction in the ETF space, and Singapore represents less than 5 percent of total assets under management for ETFs in Asia-Pacific. However, over the last three to four years there has been significant growth in ETFs—the number of ETFs in the region, according to etfgi.com, has grown from 486 in 2013 to 802 as of September 2016—and the focus has been on products that are right for institutions, adds Kerr. Some investors are coming back onshore, enticed perhaps by tax effectiveness of investing locally rather than going offshore, which could benefit Singapore and other emerging markets in the region. 

“Traditionally, investors follow liquidity,” she says. “But now we are starting to see local products gaining critical mass in terms of attractiveness.”

McCareins says that the appetite for passive investments in Singapore and broader Asia-Pacific is continuing to grow. This is based on a convergence of three factors. The first is that active managers have struggled to perform recently compared to their respective benchmarks. Second, new regulations have encouraged the implementation of passive strategies over active to help improve transparency and monitoring demands in the region. The third is fee pressure, not only in the absolute sense—the level of management fees—but also in terms of expected returns, which are forecast to be below historical levels, McCareins says. 

Investors are continuing to look at index providers as a means of gaining market exposure, and in some cases also looking at diversifying the index providers that they work with. But in Singapore, there is still a bit more bias for active management strategies, McCareins says. “But where I’m seeing more demand is in the factor-based and smart beta indices, version 2.0 of what are traditional index-based approaches and how you think of active design and passive implementation to optimize around certain factors and risk exposures,” he says.

SGX’s Karaban says the main driver toward factor-based indices as well as passive investments, in general, is that traditional active asset managers are underperforming their benchmarks. With passive strategies, there is more transparency and it tends to be carried out in a low-cost fashion, he says. 

Like McCareins, he says smart beta and factor-based indices are becoming more popular in the region, and especially so among institutional investors. “More specifically, the market is now focused on some volatility controlled strategies. No one is really prepared to take a directional view on any asset class. There are different ways to try and control for risk—you can take a multi-asset approach or use equity-risk factors to achieve desired risk factors,” he says. 

Beyond Singapore

All investors must decide whether to use active or passive strategies, or the growing trend toward factor-based investment approaches, or even a combination of all three in their portfolios. “Each approach has its own merits depending on the efficiency of an asset class, the stage of economic cycle, the ability to effectively monitor investments and investor risk tolerance,” McCareins says. 

Joel Coverdale, head of Asia, excluding Japan, for risk management solution provider Axioma, sees the market in Asia continuing to embrace smart beta-type products and strategies. “There has been a clear trend recently for asset owners to take more control over their investment portfolios and in-house more of the actual day-to-day management. The appetite for outsourcing to active managers into products producing benchmark +2 percent for high fees has dissipated in an environment of low growth,” Coverdale says.

So if Asia-Pac as a whole is moving in this direction, can the relatively small Singaporean market keep up with its peers in Hong Kong, Japan, and Australia? 

Clare Witts, head of relationship management for Asia-Pacific at execution broker ITG, says the more concentrated the market is, the harder it is to efficiently trade large rebalances or benchmarked portfolios without making a big impact. 

“If you’re running a passive investment strategy, cost management is really at the heart of everything you are aiming for,” she says. “Passive managers are looking to track as close as possible to the benchmark and not have any portfolio returns taken away by costs, which could include transaction costs.” This is why transaction-cost analysis (TCA) tools will take on even greater importance as the market matures. 

According to data published by ITG, in the third quarter of 2016, the average estimated cost of trading $100 million in Singapore was about 40 basis points, whereas in Hong Kong it was only 15 basis points. Due to the relative low volume of trading done in Singapore, it is more expensive to trade $100 million there than it would be in Hong Kong, Australia or Japan. Trading in institutional-size in a smaller market will cause more of an impact on the market and cost of trading than it would in a larger market. 

“The larger the market, the less material the $100 million is, and the less impact your trade is going to have on the market,” she adds. 

Transparency Is Key

One of the main challenges in taking advantage of passive strategies is actually having the sophistication to identify the sources of desired return and then isolating those sources so that the product actually exhibits a performance that is most closely aligned with the source of return, says Coverdale.

“This is particularly important with respect to smart-beta strategies, where the return sources are commonly alternative to the standard, cap-weighting approach of building mainstream indexes,” he says. 

Coverdale says that among the key determinants for success in launching passive products is transparency. Investors should understand what they are putting their money into, how the products are constructed, the risks and exposures involved, and last—but not least—the expected returns on the product. This is only achievable if a rigorous, methodical and clear approach is taken toward constructing products.

“As a consumer, I would be dissatisfied if I bought a Ferrari, but the performance turned out to be more like a Ford because someone switched the engine without my knowledge. Why should investment products be any different?” Coverdale says. “Smart beta as a concept is a powerful methodology that can bring significant benefits to investors, including but not limited to, lower fees and diversification. However, those benefits are only realized if the products are fit for purpose. That’s why transparency is so important ensuring end-users get what they expect.” 

At the end of the day, passive investment strategies enable low-cost market exposure coupled with liquidity and transparency. But it is how asset managers are able to refine that exposure and work toward value, volatility and quality to enhance the prospective risk-return trade-off. These are the challenges that the SGX—and its neighboring exchanges—will face as it tries to entice passive flow in 2017. 

Salient Points

• The ETF market in Singapore makes up less than 5 percent in total ETF assets under management of the whole of Asia.
• After launching its first bespoke product, SGX APAC Dividend Leaders REIT Index, SGX Index Edge aims to bring a suite of new indices to the market in the next six months.
• The Singapore Exchange is seen by many as an exchange that puts itself at the forefront of technology and innovation.
• Although Singaporean investors tend to prefer more active management, the trend is changing as traditional active managers have been underperforming their benchmarks.
• Methodology and the construction of a passive product is important, but so is transparency.