To help promote Hong Kong's asset management industry, the Financial Secretary announced in Wednesday's budget that he will extend the stamp duty concession for the trading of exchange traded funds (ETFs). But what are ETFs, where do they come from and why are they becoming popular?

ETFs are open-ended mutual funds that track a recognized market index. Investors can sell and purchase them throughout the day the same as an individual stock. State Street Global Advisers (SSgA) was the first fund firm to introduce ETFs to the US in 1993. ETFs have become the fastest growing funds over the past two decades. According to BlackRock, a fund management company, global ETF assets under management increased from US$40 billion in 1999 to US$1 trillion last year. SSgA also manages the largest gold ETF in the world. The market value of this gold ETF is larger than that of Barrick, the world's largest gold miner.

ETFs have become popular in China. There are 7 ETFs listed in mainland stock exchanges and 95 ETFs listed in Hong Kong stock exchanges. It is possible to buy ETFs from more than 15 countries, ranging from China to Korea and Russia. That ETF assets under Hong Kong and mainland stock exchanges are the second largest ETF market in Asia which illustrates the popularity of ETFs.

Most ETFs are index funds because continuous disclosures of portfolio holdings are required to maintain the efficiency of arbitrage process in ETFs. In theory, the market price of an ETF is decided by supply and demand. That supply and demand is determined by underlying portfolio values.

ETFs, however, are not guaranteed to trade at the net asset values of their underlying holdings all the time, due to the different time zones of stock market indexes, transparency of the targeted stock index and market liquidity.

The Tracker Fund of Hong Kong (TraHK) was the first ETF in South-East Asia. In line with the operation of an indexing way, the TraHK is to track the performance of the Hang Seng index, which is composed of 45 constituent stocks.

Like stocks, ETFs are easy for individual investors to trade. One of the advantages of ETFs is a low-cost way of fund investing. The average annual expense ratio of US-based ETFs were less than 0.5 per cent. Fans of indexing or passive investing argue that few fund managers are able to beat the market consistently over the long term. For example, less than 30 per cent of actively managed China funds beat the relevant market index over the past five years in Hong Kong.

With more than 1,000 actively-managed mutual funds in Hong Kong, you are swimming in an ocean of funds. It is not surprising that you may feel bombarded by various fund advertisements. You may need to take an investment course on how to choose funds to figure out the application of technical measures such as (1) beta, a measure of fund's sensitivity to the market index; (2) alpha, a proxy of the fund manager's ability; (3) Sharpe ratio, a measure of mutual fund's risk-adjusted returns. Even if you pass the course, it is still not easy for individual investors to pick out the gifted fund managers in the market.

Index funds only amend their holdings when the index does. The dark side of indexing arises when you hold some stocks you don't like in the index. ETFs are not accountable for such moves, as the responsible parties are the committees for an index, which can be sealed off from market view and criticism.

It is possible to buy bearish ETFs in the US. ProShares, the world's largest manager of leveraged and inverse ETFs, provides bearish ETFs to hedge stock portfolios against market declines. For example, UltraShort S&P 500 ProShares is the first ETFs designed to go up when the S&P500 goes down with a multiple daily basis. It is understood that shorting positions on financial assets requires individual investors to establish a margin account to borrow relevant securities. The bearish ETFs may offer you a user-friendly financial tool for managing your portfolio. Of course it is your responsibility to check the reliability of such ETFs, to track as closely as practicable the inverted performance of relevant indexes. There are also specialized ETFs with a focus on emerging markets, different investment style, commodities and foreign exchanges.

Warren Buffett has noted that "most investors will find the best way to own common stocks is through an index fund that charges minimal fees. Those following this path are able to beat the net results delivered by the great majority of investment professionals." The growth of exchange-traded funds (ETFs) over the past decade has allowed investors to execute this investment idea.

Ringo Chan is a Programme Director at the University of Hong Kong SPACE. The views expressed are entirely his own.

(HK Edition 02/26/2010 page2)