25 July 2019
By Lum Kar Hoe (Assurance Senior Manager) and Joseph Lee (Assurance Manager), PwC Malaysia
Most of us are familiar with how funds for investment are typically managed. Fund managers usually select securities to generate excess market returns (known as ‘alpha’) in an active investment strategy.
Proponents of passive investing, on the other hand, believe that one cannot outperform the market in the long run. So it makes better business sense to invest in the market. They believe that the low fees and the effect of compounding returns allow it to outperform active investing in the long run. This theory is popularised by the much hyped USD$1 million wager by Warren Buffett where he bet that the performance of a hand-picked portfolio of hedge funds will not outperform the broad market represented by the S&P 500 index fund over 10 years. Needless to say, he won.
Let’s take a closer look at the investing industry in Malaysia. Assets under management (AUM) in the country stands at RM 787.24 billion as of 31 May 2019 according to Securities Commission’s latest statistics. This is the size of the regulated active investing industry in Malaysia.
Compare that with the size (market capitalisation) of exchange traded funds (ETF), a form of passive investing, which is only a paltry sum of RM2.058 billion, and this is growing at a mere compounded annual growth rate of 2.63% between 2016 and 2019.
Source: Exchange Traded Fund statistics, Securities Commission
It is estimated that investors pay fund managers in excess of RM1.5 billion in management fees annually. Savings in these management fees would increase the performance of the fund, especially with the effect of compounding returns.
Globally, many fund managers are beginning to advocate for passive investing, led by players such as Vanguard and iShares by BlackRock which have launched numerous ETF funds. ETFs are listed funds which comprise a basket of securities that are linked to a particular index. The fees are low as the funds are made up of constituents of an index which means that fund managers do not need to actively evaluate the composition of the portfolio.
The low-cost investing approach also aligns with the proposition by digital investment managers (robo-advisors) which are heavily automated, allowing them to price their products at low fees. In our earlier blog, we discussed how robo-advisors can be supported by a low-cost regime. ETFs can fill this gap in the market. In Malaysia, the emergence of two robo-advisors, StashAway and GAX MD, could see the growth of ETFs and new launches increasing their investable universe to benefit investors in Malaysia.
Various legislations have been put in place to encourage the growth of ETFs in Malaysia. The Securities Commission has revised the ETF guidelines to support the development of new ETF products such as futures-based ETFs, synthetic ETFs, physical commodity ETFs and smart beta ETFs. We expect to see ETFs of this nature launched in H2 2019. In a bid to further stimulate the industry, regulators have implemented changes such as reducing the capital requirement for an ETF issuer from RM10 million to RM2 million, and exempting stamp duty over ETF trades.
Despite the initiatives above, there are still hurdles to be overcome before the full potential of ETFs can be realised.
i) Investor education
There is a general lack of awareness within financial wealth management circles in Malaysia. Traditional active fund management will continue to retain its popularity for the time being as they are promoted by agents who earn a commission from the sales of these products.
ii) Size of ETFs
Given the small size of ETF funds, it would be difficult to achieve scale. Recently, a local fund manager announced plans to wind up one of its existing ETFs. Due to the small size of the fund, its increasing total expense ratio contributed to a high tracking error of the fund against its benchmark index.
From an industry point of view, the Management Expense Ratio (MER) which is an indicator of the fund's assets used for administrative and other operating expenses is steadily decreasing as the total AUM of ETFs increase. The average MER for ETFs has decreased from 1.02% in 2017 to 0.87% in 2018. However, this is still far from what developed ETF markets are achieving in terms of cost efficiencies. The average MER for U.S. open-end mutual funds and exchange-traded funds fell to 0.48% in 2018, down from 0.51% in 2017.
iii) Lack of liquidity
Market makers could play a role to provide liquidity in this space. But, because they earn a spread in providing liquidity to the ETF, this may be counterintuitive to the premise of ETFs being low cost. In 2018, the total ETF trade in Malaysia for the year amounted to RM121 million at the back of the market capitalisation of ETF funds of RM2 billion, a mere 5% turnover according to Securities Commission’s latest statistics.
The existing ETF offerings in Malaysia are designed to largely mimic the performance of the market at large, while some ETFs cater to certain sectors or for Shariah investing. We see the development of thematic ETFs moving forward, which will offer investors low-cost customised exposure based on global trends. Access to emerging thematic investing strategies such as global sustainable investing are previously restricted to institutional investors and high net worth investors. But ETFs could potentially change the landscape of the investing scene, offering a more level playing field.
Sustainability and responsible governance is clearly the way forward, shaping the demand for such ETFs. Other examples, influenced by megatrends include:
These ‘megatrend’ ETFs carry exposure to companies with potential high returns but comes at a higher risk. Features of futures-based ETFs, such as leveraged and inverse ETFs enabled by SC’s recent revision to the ETF Guidelines, allows investors of such ETFs to refine their risk.
Infrastructure is already in place as we can see from the updates and changes to legislations to encourage the growth of ETFs. Players advocating low-cost investments have launched their services in Malaysia, and are building their presence in the robo-advisory space. Moving forward, passive investment may finally give mutual fund managers a run for their money. This space will be an interesting one to watch.