HONG KONG, Feb 18 (Reuters) - Investors facing zero interest rates in the developed world are turning to Asian debt for higher returns through exchange traded funds (ETFs), driving a nearly 50 percent rise in assets under management last year.
At about a tenth of the size of Europe's volume and a fraction of the U.S. market, Asian bond ETFs have plenty of room to grow but may face limits from structural problems that they can only partly address by pooling bonds in an index.
Sweden last week helped to accelerate the search for yield when it joined the global race to adopt negative interest rates to stave off deflationary pressures.
"ETFs allow investors the flexibility to trade in much smaller amounts than what they would otherwise have to do if they wanted to buy Asian debt and also gives them exposure to a wider array of assets," said Keith Taylor, a portfolio manager at BMO Asset Management.
The ABF Pan-Asia Bond Index fund, among the oldest and the biggest in the region with $3.14 billion in assets, has paid out about 25 percent in total returns since 2010, according to Thomson Reuters data.
Guotai SSE 5-year China Treasury note ETF has returned nearly 9 percent since its launch in March 2013.
Assets under management (AUM) by fixed income ETFs in Asia stood at $11.8 billion by end-2014, up from $8 billion in 2013, growing at a faster pace than in any other region, estimates by Blackrock and Deutsche Bank show.
In comparison, Europe stood at $104 billion and the United States at $312 billion.
BMO Asset Management eyed that growth potential when it launched its first fixed income ETF in Asia last November, focusing on dollar-denominated debt Asian companies had issued.
BMO's bond ETF, which has garnered about $12 million since its launch, benchmarks itself to the Barclays Asia USD investment grade index.
Going by its untapped potential, Asian bond ETFs are set to make bigger inroads in an area traditionally a haven for equities.
Fixed income ETFs in Asia account for 6 percent of total ETFs, Deutsche Bank said. In developed markets, they account for 16 to 25 percent.
Bond ETFs in Asia appeared on investors' radar only in the last few years, following record Asian corporate issues on the back of low interest rates.
Despite their impressive growth, there are limits to how much ETFs can repackage Asian bonds to ease the risk posed by shallow trading liquidity and diverse regulatory regimes. These weaknesses could hold back growth, fund managers say.
"Two of the biggest markets in the region, India and China, remain accessible only via quotas and Asia is a very heterogeneous market, which means investors have to navigate through many regulations across different jurisdictions, unlike other regions," said Marco Montanari, head of passive asset management at Deutsche Asset and Wealth Management, which manages 40 billion euros globally.
Moreover, ETF growth may be curbed by foreign investors' worries about Asia's illiquid secondary bond markets and Asian investors' preference for local bonds rather than managed portfolios.
A lack of trading liquidity may not be a problem for closed funds, but if ETFs face large redemptions or purchase orders they may find it hard to locate the credits making up the bond index despite having access to multiple trading channels.
"Asia is a very technical market where liquidity trends can be quite patchy and for U.S. real money investors who are accustomed to trading in large clips, that can be a problem," said Dong Nam, head of credit trading and sales at Mitsubishi UFJ Securities in Hong Kong. (Editing by Jacqueline Wong)