By Genevieve Cua

THE exchange traded funds (ETF) revolution has hit Asia even though you're unlikely to discern it from those listed on the Singapore Exchange.

Providers of ETFs, such as iShares of Barclays Global Investors (BGI) and State Street Global Advisors (SSGA), report a growth of more than 40 per cent last year, at a time when the bear market would have pulled down market values in Asia by well over 40 per cent.

BGI, for instance, says assets under management (AUM) of iShares ETFs in Asia ex-Japan reached US$4.3 billion at end-December, a growth of 43.7 per cent over 2007. Globally, iShares saw a record year in 2008 with net inflows of US$89 billion compared to US$70 billion in 2007. Based on an ETF market report by Deutsche Bank, BGI is the second largest provider in Asia with US$6.5 billion in AUM.

Sammy Yip, SSGA's ETF head for Asia, also says net subscriptions grew by more than 40 per cent last year.

'I think the credit crisis helped Asia's ETF development... People became more aware of the importance of having a diversified portfolio, and ETFs play an important role there.'

ETFs are a relatively recent entrant into the Asian market. In developed markets like the US, investors have taken to them as a cheap and efficient way to get exposure to the market. An indexed ETF's expense ratio can be as low as 20 basis points, compared to over 2 per cent for an actively managed fund.

For portfolios, ETFs lend themselves to a core/satellite approach. ETFs which offer pure market returns form the core, and the satellites may be higher risk, less liquid vehicles which include actively managed funds and hedge funds. In Singapore some advisers have begun to offer 'alpha' or actively traded funds that invest only in ETFs. Through broker sites such as Saxo, investors can also access numerous ETFs listed in a number of exchanges.

But as ETF penetration grows, investors should be aware that not all are created alike. While most ETFs are designed to track an underlying index, there are actually two to three types of structures, each with advantages and risks.

The first type is what most investors would be familiar with - ETFs that replicate an index by physically investing in the index's component stocks. SSGA's streetTRACKS STI is an example of this. Then there are ETFs that replicate the index through a 'representative sampling'. As the term indicates, this takes a sample of stocks that approximates the index's performance.

Then there is the synthetic structure, where index performance is replicated through derivatives, usually a swap arrangement. This is typically done for markets where access may be difficult and liquidity poor. Those listed here by Lyxor and Deutsche Bank's db x-trackers series are swap-based ETFs. ETFs that track the China A shares indices on the Hong Kong exchange also do so through derivatives.

Cash-based ETFs, which seek to buy an index's underlying shares or a sampling of shares, offer the comfort of transparency and are relatively easy to understand. The drawback is that there may be deviations from the index, which in industry parlance is called a 'tracking error'. This occurs when weightings of underlying stocks shift, or the components are changed and the portfolio needs to be rebalanced, for instance. Performance between ETFs that track the same index may vary. The performance of DBS STI ETF, for example, has lagged the FS STI Index by more than 2 percentage points.

Managers of cash-based ETFs may lend out the securities. While this generates revenue for the fund, it incurs counterparty risks. SSGA says it does not engage in securities lending for its Asian ETFs.

Swap-based or synthetically structured ETFs offer the advantage of a tracking error that's virtually zero, says head of db x-trackers for Asia, Marco Montanari. In a swap based ETF, the fund holds a basket of securities which may be completely unrelated to the index it is linked to. It enters into a swap agreement with a counterparty where the latter undertakes to deliver the performance of the index to the fund. The fund on its part will deliver the returns of its basket of securities.

Such an arrangement, of course, also raises the spectre of counterparty risk which loomed large through this recent credit crisis. A case in point are the London-listed commodities funds of ETF Securities, which had AIG as a counterparty. As AIG teetered on the brink last year, the funds plunged in value and were suspended from electronic trading.

Yet another issue is that there may be little transparency on the types of securities held as collateral for the swaps, which may themselves plunge in value in a crisis. There is of course no guarantee on the value of the collateral.

There are ways, however, to mitigate the risks. European funds, such as those structured under the UCITS III umbrella, are subject to a cap of 10 per cent in terms of counterparty exposure. UCITS refers to the authorisation regime for funds in Europe.

Managers themselves can go the extra mile. For db x-trackers, Deutsche Bank as the ETFs' swap counterparty has set up an account with the fund custodian in which cash and securities are pledged to the account. The collateral is subject to concentration limits. There is for instance a 4 per cent cap on any single security. iShares may seek to diversify counterparties. It also seeks to educate investors by posting updates on how it is managing its funds' counterparty exposures on its website.

David Gardner, iShares Asia Pacific head of sales, says: 'In many pure single party swap contracts, there is no public transparency on who is behind the product. We seek to democratise information.'

Adds Jane Leung, iShares Asia ex-Japan senior director of product: 'It is crucial that investors read the prospectus and understand the product features and choose providers that are market leaders that have a proven history and infrastructure.'

Daryl Liew, investment director of advisory firm Providend, says his preference is for 'vanilla' cash-based ETFs. The firm runs a series of funds investing in ETFs. 'We recognise that in certain instances this isn't possible, such as in the commodities space . . . We look to manage the overall counterparty risk exposure. If commodities comprise 5 to 10 per cent of the portfolio, that risk is manageable.'

Meanwhile ETF providers are optimistic on the trajectory of Asian growth. Says iShares' Mr Gardner: 'I think there are a number of forces that are neutral to any domicile. People want transparency. Asia is an evolving market. People are very interested and want to understand how indexed products can work alongside active funds in a portfolio. That's something I've seen among large sovereign wealth funds and small retail accounts.

'Firms like ours have to remain committed to that demand.' The group expects to launch more pan-Asian and emerging markets products.

BGI expects the global ETF market - estimated at US$711 billion at end-2008 - to hit US$1 trillion by the end of this year, and US$2 trillion in 2011.

This article was first published in The Business Times.