Leveraged and Sector-Specific Notes in Asia: Trends and Potential

Structured Products Group Merrill Lynch Pacific RIM

July/August 2010 Shreya Gandhi Under the guidance of Tan Beng Wah and Tan Yew Kiat

Important Notice
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Objectives + Outline

To analyze the potential for a listed structured note in Asia which:

Tracks a sector-specific index

Is leveraged

Using sector-specific and leveraged ETFs from around the world as proxies for potential interest in this product space, we examine the following:
Current trends and growth in the ETF market in Asia Asian investors in US-Listed Leveraged ETFs Turnover and Trade Volume of the Asian ETF market Asian Investors in US-Listed Sector-Specific ETFs Negative aspects an argument against Asian listed ETFs

Opinions from market leaders

Current Asia-Focused, US-Listed ETF Growth

Trends: Asian economy is growing IMF economists have predicted Asian growth for 2010 between 7% to 7% increased Asian wealth will attract Asian investors and increased Asian market growth to attract foreign investors Asian ETFs will grow in demand and value

iShares MSCI South Korea Index Total Return +3.55% YTD

iShares MSCI Malaysia Index Total Return +16.62% YTD

iShares MSCI Taiwan Index Total Return 4.32% YTD

iShares MSCI FTSE/Xinhua China 25 Index Total Return 1.34% YTD

$564MM IPO

Current Asia-Focused, US-Listed ETF Growth

iShares MSCI India ETF Total Return +1.45% YTD iShares MSCI Indonesia Investable Markets Index Fund Total Return (1 Month inc. 5/7/10) + 7.56% iShares MSCI Singapore Index Fund Total Return +8.23% YTD iShares MSCI Japan Index Fund Total Return -0.42% YTD

Past Trends

Asian economies are becoming more sophisticated and investors more wealthy Past trends show that Asian ETFs are growing in line with Asian economies However, there is a low number of Asians investing in US-listed leveraged and sector-specific ETFs Asia-listed leveraged ETFs still do not exist Apparent trend that US and European ETPs are currently experiencing a high-growth period Asian ETFs are still relatively untapped presents an opportunity for BofAML

Asian markets and investors will turn to products like ETFs in the near future
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Asia-Pacific Trends
In China and Malaysia, global ETF providers need a local partner slowed growth (SS) Japan: Retail investors hold the majority of ETF assets (SS) Hong Kong: Individuals are the primary investors (SS) Asia Pacific investors tend to invest by region (SS) According to T.K. Yap, Executive Director, OCBC, Most ETF trades in Singapore are professional, not retail; ETFs have not yet caught on with retail investors. This is probably due to misconception: liquidity is viewed as being the dealt volumes whereas it really should be defined by the bid and offered volumes. Investor education for retail has been lacking. According to BlackRock, in the more developed markets like Hong Kong and Singapore, it is mainly institutional investors who are using ETFs, but there is real potential for the retail market to develop.

Asia-Pacific Trends
In order to promote a vibrant ETF marketplace, we need to create awareness and interest of the product class and its key benefits amongst investors, existing or new, institutional or retail, said Ms Magdalyn Liew, assistant vice-president at SGX. Recent market declines and increased volatility have caused investors to seek safer, beta investments ETF index tracking beta products have benefited from this trend in the US and Europe (DB) Recent increase in ETFs offered, and diversity thereof, providing investors with a larger variety of profiles to invest in, including sectors that are typically difficult to access (DB) Increased coordination among Asia-based regulators, ex: recent coordination between Taiwan and Hong Kong regulators to allow ETFs to be cross listed in both markets. (DB) Fragmentation is one of the major impediments to the growth of the ETF market in Asia (DB) Because market makers in Asia can hedge their exposure more efficiently during Asian market hours, and they can compare ETF prices in real time with the value of the index, Asian ETFs listed in Asia would have better bid-offer spreads than those listed in the US/Europe, which would make them more likely to do well in Asia.
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Asia-Pacific Trends
Especially out here in Asia, if you look at the percentage of assets managed on a passive basis, its very low. If you look at the US, its probably 30%, the UKs 30%, the continent is probably 5-10 percent. Here, its really single digit. So there is an opportunity for more money to be managed on a passive basis, said Deborah Furh, BlackRocks global head of ETF research and implementation strategy. Asian ETF growth for 2009 high in all sectors except Currency. Volume concentrated in Equity ETFs Institutional investors and professional investors have traditionally played the largest roles in the ETF market, but off late retail investors are entering the market and demand is high According to Mr. Chan Kum Kong, senior vice president for ETF Investments at DBS Asset Management (DBSAM), retail investors are increasingly embracing ETFs as they see the benefits of utilizing them as a tool for investment portfolio asset allocation.

Asian ETF Market

Asia Pacific ETF Growth was incredibly high (27.5%) in 2009 especially in Equity, Fixed Income and Commodities. It is a good time to take advantage of such high growth numbers which may temper off once ETFs become more established. BofAML can issue structured products to gain market share and first-mover status on leveraged and sector-specific funds.
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Asia Pacific Volume

Asia - Pacific ETF Turnover Australian SE Bombay SE Bursa Malaysia Hong Kong Exchanges Indonesia SE Korea Exchange National Stock Exchange India New Zealand Exchange Osaka SE

December-09
423.24 0.14 2.94 5,214.37 0.00 1,523.90 137.33 3.24 1,974.65

January10 349.16 12.79 0.93 6,298.10 0.05 1,547.34 125.48 4.70 1,894.45

Year-to-Date
349.16 12.79 0.93 6,298.10 0.05 1,547.34 125.48 4.70 1,894.45

Shanghai and Hong Kong lead the Asia Pacific Market for ETF turnover. Shanghai SE and Korea Exchange lead the Asian Pacific Market in terms of Number of ETF Trades.
Asia - Pacific ETF # of Trades Bombay SE Bursa Malaysia Hong Kong Exchanges December10 0.3 0.6 160.6 January-10 14.7 390.0 230.7 Year-toDate 14.7 390.0 230.7

Indonesia SE
Korea Exchange National Stock Exchange India New Zealand Exchange Shanghai SE Shenzhen SE Taiwan SE Corp. The Stock Exchange of Thailand

0.0
448.6 149.8 0.4 991.0 347.0 67.9 8.9

0.1
501.2 110.0 0.4 914.0 267.9 83.0 7.7

0.1
501.2 110.0 0.4 914.0 267.9 83.0 7.7

Shanghai SE
Shenzhen SE Singapore Exchange Taiwan SE Corp. The Stock Exchange of Thailand Tokyo SE

9,247.38
3,297.91 317.19 490.89 9.63 1,819.20

8,105.23
2,294.90 245.73 627.00 9.49 2,036.22

8,105.23
2,294.90 245.73 627.00 9.49 2,036.22

Source: World Federation of Exchanges

Source: World Federation of Exchanges

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Professional Insight
Insight From Marco Montanari, Deutsche Banks director of ETF business in Hong Kong (June 2010) What we are seeing is that asset managers are looking at moving into the ETF market. This is not just in China, where everyone is looking to list an ETF, but in each individual market. You have the local fund providers trying to set up a master feeder or an independent structure. They can see that in the long run, the fund market will segment and that ETFs will become a key product. The biggest problem is that you cannot get passport funds across Asia, so you can only be a local player. That is where global players like Deutsche Bank have the advantage. Insight From Nick Good, managing director, head of iShares Asia-Pacific at Black Rock (June 2010) Total trading assets of ETFs in the Hong Kong exchange is expected to grow 30 percent this year and next iShares will launch more ETF products to meet market demand with cross-border listing products being considered.

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Professional Insight
Since no single sector, style, or stock consistently outperforms its peers, having a diversified portfolio invested in ETFs tracking various asset classes can help manage risk and minimize overexposure to a single stock or market segment. We see an increasing use of ETFs by all types of institutions asset managers, pension plans, insurance companies, sovereign wealth funds, hedge funds, as well as retail investors Institutional investors can use ETFs to pursue a variety of different investment objectives and strategies including core/satellite models, transition management, portfolio completion, hard-to-reach asset classes, and restricted markets Retail investors can use ETFs to gain quick and easy diversification, gain exposure to restricted markets, and implement asset allocation strategies Since the financial crisis, there is an increasing acceptance of ETFs by the retail market in Asia As more and more investors are discovering the benefits of ETFs, the popularity of ETFs is likely to continue to grow. According to BlackRocks estimation, the global ETF market can grow by 20-30% in 2010.
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Leveraged ETFs: Trends & Potential Transparency

Asian Investors tend to invest larger amounts into leveraged ETFs where they have direct visibility of the market being tracked

Not many Asia-centric leveraged ETFs exist

Potential for Asian-listed ETFs tracking Asian sectors and markets rather than foreign ones or US-Listed ones Because: Asian investors would be more comfortable investing in markets they are familiar with It would be easier to incentivize market makers for ETFs in their own regions Asians investing into US based Asian ETFs face a risk posed by time difference prices are based on estimations, or non-live estimations, because the US markets are usually closed during Asian market hours having listed structured products linked to ETFs based in Asian exchanges would make ETFs more transparent to potential investors and expose them to the real-time pricing ETFs are valued for. This would make such investments easier and more accessible Time difference price changes could have significant gap risk oversight
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Leveraged ETFs: Trends & Potential Volume/Liquidity

High growth forecasts for Asia would attract foreign and local investors to inevitably profitable Asian investments According to Seeking Alpha and Yahoo Finance (July 28, 2010), the U.S. Unit of ETF Securities is set to market a physical gold ETF with the storage vault in Singapore movement of U.S. investors into safe Asian economies Asian investors currently prefer to trade ETFs on the US/European markets because of higher trade volume there More popular ETFs (SPDR Gold Shares, iShares FTSE/Xinhua China Index, iShares MSCI India ETF etc.) have caught on well with retail investors in Asia, but providing direct market access to ETFs through SGX and increasing liquidity would make investors more likely to experiment providing impetus for growth of Asian ETFs

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Leveraged ETFs: Trends & Potential Risks to Investors

There have already been examples of consequences with leveraged ETFs so second generation leveraged ETF investors will be more risk aware They are often considered more similar to gambling than investing High volatility and uncertainty increases risk When leveraged ETFs lose money, they lose two or three times the indexs losses Tracking Error ETFs not delivering results and tracking benchmark results as promised

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Leveraged ETFs: Trends & Potential Risks to Bank

Spreads Risk lower trading liquidity leads to larger spreads and increases costs Tax Risk more complex tax issues and higher percentages to be paid Counterparty risk owning a stake in the funds that make up the index is exposure to the risk of those companies

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Asian Investors in US Leveraged ETFs

KDB Asset Management (South Korea), tends to invest small numbers of shares into US Index-Linked ETFs About 20 small investments into US Leveraged ETFs Fuh-Hwa Investment Trust (Taiwan) 48,000 shares in ProShares UltraShort QQQ Korea Investment Trust (South Korea) 500 shares in ProShares Ultra Oil & Gas Nomura Holdings (Japan) 100,000 shares in ProShares UltraShort Yen Mirae Asset Global (Hong Kong) 278,618 shares in ProShares UltraShort FTSE/Xinhua China 25 Chinarock Capital (Hong Kong) 160,000 shares in ProShares UltraShort FTSE/Xinhua China 25
TREND: Asian asset managers are using US-listed leveraged ETFs in their funds investment banks, hedge funds, asset management companies

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Asian Investors vs. Non-Asian Investors

Asian vs. Non-Asian Investors in iShares FTSE/Xinhua China 25 Index ETF (Non-Leveraged)
Asian vs. Non-Asian Investors in ProShares UltraShort FTSE/Xinhua China 25 ETF (Leveraged)

Asian Investors Non-Asian Investors

Asian Investors Non-Asian Investors

Reason for above observed trend (more Asian investors in ProShares Leveraged ETF rather than iShares non-leveraged ETF could be explained by a) Non-Leveraged ETFs are more easily available on Asian markets so investors dont need to seek investments based in the US or b) The leveraged ETF seeks twice the inverse of FTSE/Xinhua whereas the non-leveraged ETF seeks to represent the performance. Singapore ETF turnover grew 56% to S$4.6 billion in 2009, the third straight year in which record turnover was achieved. (SGX 4)
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Analysis Leveraged ETFs

The growth in Asian demand for non-leveraged ETFs as well as the increasing sophistication of the Asian markets will inevitably cause significant demand for nontraditional investments such as leveraged ETFs. However, these seem more suited

towards institutional investors rather than retail. Most of the Asian investors in US-listed
leveraged ETFs, though few, are institutional investors with lower sensitivity to losses than retail investors and greater inclinations toward high risk investments, making them the target investor group for the product. Leveraged notes would be suitable to sell on open exchanges in Asia only if all investors were clearly informed of the risk exposure and of the controversial consequences. Those who still invest after such warning will be those who track their investments and are seeking leveraged exposure. The main problem in the US/Europe was that investors were unhappy that their products were not performing as advertised. Preventing false advertisements, and presenting all information will reduce the likelihood of controversy and increase investments.
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Sector-Specific ETFs: PROS

Sector-specific ETFs track the stocks of individual industry sectors such as retail, pharmaceutical, energy etc. Sector Specific ETFs are ideal for trend traders who seek their investments over long periods

Can still generate high percentage gains if investor successfully identifies high-growth sectors
Higher numbers of Asian investors in US-listed sector specific ETFs than in leveraged ETFs because the risk factor is lower and the exposure Reduces stock-specific risk Increased tax efficiency because they trade on an exchange, insulating investors from taxable events generated by other investors The opportunity to invest in a favored sector yet avoiding the potentially negative effects a downturn in the market could have on a few individual stocks

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Sector-Specific ETFs: CONS

Expense ratio tends to be more expensive for sectors vs. broad based ETFs. Ex: Select Sector SPDR ETFs charges 0.28% per year, whereas the State Street SPDR S&P 500 ETF charges 0.09% per year Greater costs because the bid-ask spread is wider

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Sector-Specific ETFs: Trends & Potential - Risks

Investors are exposed to the sector risk and non-diversification risk, which generally will result in greater price fluctuations than the overall market

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US Incorporated Sector-Specific ETFs Asian Investors

SPDR S&P Oil & Gas Exploration & Production ETF China Investment Corporation holds 100,000 shares (China) Energy Select Sector SPDR Fund China Investment Corporation holds 4,129,901 shares (China) Financial Sector Select SPDR Fund China Investment Corporation holds 9,000,000 shares (China) Samsung Investment Trust Management holds 8,110 shares Maps Investment Management holds 824 shares SPDR S&P Biotech ETF Yuri Asset Management holds 1,730 shares Materials Select Sector SPDR Fund China Investment Corporation holds 2,500,000 shares (China) Nomura Holdings Inc holds 11,700 shares (Japan) SPDR S&P Metals & Mining ETF Deutsche Investment Trust Management holds 4,372 shares (South Korea) SPDR Dow Jones REIT ETF (Real Estate) Kyobo AXA Investment Management holds 5,159 shares (South Korea) Schroder Investment Management holds 1,504 shares (Singapore) SPDR Dow Jones International Real Estate ETF Woori Asset Management holds 9,800 shares (South Korea) Bliss Asset Management holds 8,460 shares (South Korea) Kyobo AXA Investment Management holds 7,173 shares (South Korea) SPDR Gold Trust Nomura Holdings holds 865,599 shares (Japan) Mitsubishi UFJ Asset Management holds 3,460 shares (Japan) Hyundai Investment Management holds 22,984 shares (South Korea) PCA Investment Trust holds 3,100 shares (South Korea) Maps Investment Management holds 3,063 shares (South Korea) KB Asset Management holds 3,000 shares (South Korea) Shinhan BNP Paribas holds 2,830 shares (South Korea) Franklin Templeton Investments holds 125,000 shares (Hong Kong) ChinaRock Capital holds 70,000 shares (Hong Kong) Deutsche Asset Management holds 105,048 shares (Singapore) Lion Global Investors holds 33,600 shares (Singapore) Schroder Investment Management holds 10,410 shares (Singapore) Prudential Financial holds 8,000 shares (Taiwan) China Investment Corporation holds 1,450,000 shares (China)

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Sector-Specific ETFs Asian Investors

SPDR S&P Emerging Markets ETF Woori Asset Management holds 1,330 shares (South Korea) SPDR S&P BRIC 40 ETF ING Funds Thailand holds 476,000 shares (Thailand) France Incorporated Sectorial ETFs

LYXOR ETF Commodities CRB Woori Asset Management holds 300,000 shares (South Korea)

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Analysis Sector-Specific ETFs

Asian investors are more active in US-listed Sector-specific ETFs (in absolute numbers) than in Leveraged ETFs. Sector-specific ETFs are a safer option for Asian markets and seem more viable than leveraged ETFs because they allow investors to choose certain

sectors (i.e. technology, energy, commodities etc.) in which they see growth rather than
choosing specific companies. It allows them flexibility, diversification, and ease because just one stock provides exposure to a larger underlying group of companies. There are not many sector-specific ETFs listed on Asian stock exchanges so there is definite growth potential. Sector-specific ETFs provide less volatility and risk exposure than do leveraged ETFs so would be more successful with retail as well as institutional investors in Asia.

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Buy-and-Hold vs. Daily Traders

Buy-and-hold investors look for investments which will grow consistently over time, rather than volatile and ephemeral ones Daily traders look for opportunistic investments which can make the greatest amount of

money in the shortest time

Leveraged ETFs seem to track daily market activity accurately, but have long-term tracking errors which can cause investors who have correctly predicted market trends to lose money target segment should be professional/institutional investors who track

their positions regularly

Sector-specific ETFs are appropriate investment tools for buy-and-hold investors who see growth in particular sectors non-leveraged results depend entirely on market activity rather than the structure of the product and its tracking error

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Regional Market Share

Deutsche Banks db x-trackers ranks 9th in AUM in Asia Pacific, with around 4% market share. China Fund Management and iShares have about 20% each. Singapore and Taipei each have around US$15-20 million turnover a day, and assets of around $2 billion each. Hong Kong has a turnover of around US$260 million/day, and AUM of around $20 billion. If BofAML can establish first-mover status for leveraged and sector-specific structured products, it is possible to obtain between 0.5% and 3% of the current ETF market, some scenarios for monthly revenue potential are below:
Singapore, based on USD 15 million daily turnover Hong Kong, based on USD 260 million daily turnover

% Obtained 0.5% 1% 2% 3%

30 bps $4,500 $9,000 $18,000 $27,000

40 bps $6,000 $12,000 $24,000 $36,000

50 bps $7,500 $15,000 $30,000 $45,000

% Obtained 0.5% 1% 2% 3%

30 bps $78,000 $156,000 $312,000 $468,000

40 bps $104,000 $208,000 $416,000 $624,000

50 bps $130,500 $260,000 $520,000 $780,000

*All numbers, percentages and basis points are estimated projections

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Analysis Timing
High and increasing demand for ETFs may indicate a regional trend and interest in more sophisticated investment schemes, which means Asian investors are likely to experiment with leveraged ETFs. However, they should probably be introduced during a

market upswing where confidence is high and risk sensitivity is lower than usual.

Sector-specific products are less risky and should be introduced to the market by BofAML as there is a relatively low but inevitably rising percentage of such products. These can be introduced during a bear market because they allow investors the opportunity to single out sectors which they believe will beat the market even in a downturn.

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Analysis - Market Gaps in Singapore

Leveraged ETFs are not currently popular with Singaporean investors because of the 0 time overlap with US trading hours Issuing leveraged structured notes in Singapore where investors have the opportunity to track the minute-by-minute prices would make Asian investments more feasible

Most of the popular ETFs in Singapore are regionally focused, and SPDR Gold Shares ETFs to avoid
Low number of ETFs in commodities, sector-specific, currencies and bonds Potential Market Regionally focused leverage notes could attract investors with strong views but must be attractive enough to take investors away from currently available (and more predictable) regional non-leveraged ETFs According to Thorsten Michalik, head of ETFs for DB Asia, about 70% of ETF trade in Asia is China-Related Less potential because there are many established opportunities

Not much money managed on a passive basis in Singapore (compared to 30% in the US and Asia) shows future growth of ETFs
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ETFs vs. Unit Trusts

ETFs Passively managed Bought and sold on the stock exchange through a broker No sales charge Brokerage fees of 0.25% - 0.5% and clearing fees of about 0.04% Management fees are less than 1% per annum Can be bought and sold throughout the day at real-time prices Unit Trusts Actively managed by professional fund managers Bought and sold through sales personnel on behalf of fund management houses or banks Sales charge of 3% - 5%

Management fees of 1% - 2%
Can only be bought and sold at end-ofday prices quoted by sales personnel or banks

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Why we should start this business?

An opportunity to diversify the structured products business at BofAML by introducing original products to Asia Both leveraged ETFs and sector-specific ETFs have been successful with sophisticated investors in the US and Europe

There is enough precedent of challenges, problems and recommendations for BofAML to learn from and improve upon
The market trends and background info show fast growth of the market Revenue projections (even conservative estimates) show that the business will prove to be profitable Leveraged ETFs and Sector-Specific ETFs cover both the retail and institutional investor markets

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Main Challenges
Being a first mover in the market, there may be some unprecedented challenges faced in the Asian market which were not experienced in the US and Europe due to regulatory differences in Asia Educating investors is a large but necessary burden to avoid problems

Risk management and accountability to investors

Liquidity challenges marketing is important to ensure liquidity and volume According to Joseph Ho, the ETF industry in Asia has fallen behind that of Europe both in terms of the number of products and AUM. The main culprit is a lack of a panregional regulatory regime to allow Asia domiciled ETFs to trade across the region in order to attain the necessary economies of scale, like what UCITS did for European ETFs. Market fragmentation and small market sizes led to a dearth of products, participants, and investor awareness.

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Conclusion
A structured listed note which tracks a sector-specific index is a viable business potential in Asian markets (specifically Singapore and Hong Kong) in the near future there are very few in Hong Kong and none in Singapore in ETF form, so seizing this first-mover status opportunity is crucial A structured listed note which is leveraged is a more risky option but still has potential to be successful in Asian markets because they do not yet exist in the market, and more sophisticated and risk-seeking investors will be potential buyers For both of the above propositions, the survey of the current ETF market as a proxy for potential growth has proven that there is market potential for Asian structured products to reach the levels of those in the US and Europe as long as the marketing and structuring of the products is done in a way that Asian investors will be

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