Policymakers in Hong Kong must act to strengthen its position as a regional hub for exchange traded funds or risk losing more ground to regional rivals, according to a government advisory body.

The warning by the Financial Services Development Council reflects concerns that competitors, including China, Korea, Taiwan and Singapore, have outpaced Hong Kong in their efforts to promote ETFs.

In a report published last month, the advisory body wrote: “Hong Kong’s leadership position has been overtaken by Japan and Shanghai as they have introduced more innovative products. Other leading overseas markets have also enhanced their ETF platforms recently, offering an even broader range of ETFs.”

The report recommends wide-ranging reforms including measures to encourage more ETF use by pension funds and steps to boost the role of ETFs in capital flows between Hong Kong and mainland China.

Hong Kong was the second market in Asia to launch ETFs in 1999 after the first listing in Tokyo in 1995. However, activity remains concentrated in just a few products. One fund alone, the iShares FTSE A50 China ETF, accounts for almost 40 per cent of all ETF turnover in Hong Kong.

The local regulator is considering how to streamline the authorisation process to encourage more ETF launches. None of the top 20 fastest-growing ETFs launched in Asia this year were listed in Hong Kong, according to ETFGI, the consultancy.

Susan Chan, head of iShares Asia Pacific for BlackRock, the world’s largest fund manager, says launching more products is “just one part of the solution as improvements can be made across Hong Kong’s entire ETF ecosystem”.

Ms Chan says a combination of measures, including regulatory changes and a greater focus on education, are needed to create more awareness of ETFs among investors and financial advisers.

ETF usage in the US accelerated after financial advisers were required to adopt a fee-based payment model instead of relying on commission (incentive) payments from fund managers. ETFs do not pay commissions, but financial advisers in Hong Kong still receive commissions to incentivise them to sell mutual funds. This has hindered ETF adoption.

“It is early days for ETF adoption among individual financial advisers but there is rising sensitivity about fund fees and costs, which should benefit ETFs,” says Ms Chan.

Although there is no indication that the local regulator might change the rules, the private banking operations run by global operators including UBS, Credit Suisse, Crédit Agricole, JPMorgan and Goldman Sachs are moving away from paying retrocessions. All have reported big increases in their fee-based businesses in Asia.

“We are seeing tremendous increases in ETF usage on the discretionary managed platforms run by private banks, which are reporting significant growth in their fee-based business,” says Ms Chan.

But ETF adoption among retail investors remains low.

“Mom-and-pop retail investors in Hong Kong just do not think about ETFs at the moment,” says Ms Chan.

Deborah Fuhr, co-founder of ETFGI, says ETFs face tough competition in Hong Kong from structured products that are popular among retail investors because they boost returns and do not attract stamp duty.

“The regulator does not permit leveraged or inverse ETFs to be listed in Hong Kong. But we know from elsewhere that leveraged ETFs are popular among retail investors as a way to amplify returns,” she says.

ETFs are also not widely used by pension fund managers. Regulators have only approved a limited number of these products for use by pension schemes, and fund managers are anxious to see these restrictions eased.

“There are many low-cost ETFs that could potentially be added to the [approved] list,” says Stewart Aldcroft, Asia chief executive of CitiTrust, the securities and funds services arm of Citigroup, the US bank.

Mr Aldcroft, a contributor to the advisory body’s report, notes that pension fund assets across Asia have doubled since 2006, to $2.4tn, and are projected to almost double again to $4.3tn by 2030.

“Pension funds are one of the potentially biggest sources of new capital for ETFs,” he says.

The inclusion of ETFs into the programme that links stock trading in Shanghai and Hong Kong could also be a “game changer”, according to Mr Aldcroft.

This would help mainland Chinese investors to use Hong Kong-listed ETFs to gain exposure to international markets.

“Mainland investors are not allowed to invest in ETFs in other overseas markets directly. This poses enormous opportunities for Hong Kong-listed ETFs,” says Mr Aldcroft.

Asian hub ambition: Investors prefer the US or Europe for ETFs

Hong Kong’s policymakers face significant challenges if they are to achieve their ambition of building the territory into an Asian hub for exchange traded funds.

Shelly Painter, regional managing director in Asia for Vanguard, the world’s second-largest asset manager, says Asian institutional investors are making more use of ETFs but they prefer to trade in the US or Europe.

“Liquidity is much better and trading costs are lower in London and New York for large Asian investors,” she says.

Daily ETF trading volumes in Hong Kong were running at $500m in October, around half the ETF business being done in Shanghai and a quarter of the activity in Tokyo. Trading volumes in the US were $80bn.

Persuading international fund managers to cross-list some of their most popular US and European-domiciled products would encourage more ETF adoption.

Supervisors in Hong Kong are open to the extension of more mutual recognition arrangements to ETFs domiciled in other countries but they insist that ETF portfolio managers should be employed in the territory, which is an additional layer of expense for international providers.

“They want to see boots on the ground running ETFs in Hong Kong,” says Ms Painter.

Investors have been pulling money out of ETFs listed in Hong Kong this year, with outflows reaching $845m by the end of October. In contrast, South Korea and Taiwan have attracted inflows of $2.3bn and $1.5bn respectively in 2015.