What should Mena investors consider when choosing an ETF?

Domicile factors such as liquidity and tax are key considerations to explore before investing in this asset class

An exchange-traded fund is a cost-effective and efficient investment vehicle to gain exposure to diverse assets. Photo: Getty Images

The global exchange-traded fund industry proved its resilience in the face of the Covid-19 pandemic as assets under management grew 26 per cent to $7.99 trillion at the end of December 2020 from the prior year. The growth continued in 2021 as a record level of net inflows brought global AUM to $8.56tn at the end of the first quarter.

While the ETF market is gaining strength in the Mena region, the industry is nascent and most ETFs available to Middle East investors are listed in the US, Europe or Asia. Globally, the ETF and exchange-traded product industry includes 535 providers that have listed 8,893 products on 77 exchanges.

With the market size burgeoning and a growing number of ETFs on offer, what are the key decisions for investors to consider when faced with a variety of these products?

Investors in the region have a degree of flexibility that is not available to their counterparts based in the US or Europe, thus providing them with a broader range of opportunity, but also necessitating more thought in the investment process. But it need not be overwhelming.

There are some simple guidelines to help investors navigate the selection process. For example, look at how domicile and different ETF structures can affect performance.

An ETF is an exchange-listed investment fund that may consist of stocks, bonds, commodities or other financial assets and can be bought and sold throughout the trading day. It is a cost-effective and efficient investment vehicle to gain exposure to diverse assets.

In each region, regulators set the standards and rules governing product creation and its sale outside the region. In the US and European ETF markets, for instance, regulations restrict investors in one region from investing in ETFs listed in another geography. However, this is not the case for Mena-based investors who can invest in ETFs in both markets.

There may be an ETF available in one market that has an equivalent exposure in another market, or there may be an ETF that is available in only one of these markets.

For Mena-based investors, it is important to consider which ETF is more aligned with their portfolio mandate.

Most investors focus on fees and size when deciding on ETF investments, but domicile-based factors such as liquidity, timing alignment and tax should also be considered in investment decisions.

Looking at exchange liquidity, there are fundamental differences between ETFs domiciled in the US versus those in Europe. The US market has higher on-exchange activity, driven by regulation and a higher participation of retail investors. In Europe, exchange liquidity is more fragmented, but a market-maker is always present to support the ETF.

While exchange liquidity is beneficial, regardless of the market, it is important to remember that ETF liquidity is primarily driven by the liquidity of the underlying assets.

Timing alignment between when the ETF trades and when underlying assets trade is another factor to consider. If an ETF is listed on a European market but the underlying assets are in the Middle East, liquidity from the trades of the underlying securities can be passed to the ETF during the overlapping trading hours.

However, when trading hours do not overlap, for instance when a US-domiciled ETF provides exposure to stocks listed in the Middle East, investors might pay a premium on orders executed immediately or risk a movement in price for orders executed the next day. Aligning trading hours to maximise flexibility, therefore, becomes an important consideration for investors.

Tax withholding on dividend distribution may seem a nuanced aspect to consider for Mena investors putting money into ETFs, but it can have a material impact on performance in the long term.

Taxes can be withheld at the portfolio level on fund investments, at the fund level on fund distributions or at the investor level on income or capital gains. Dividend distributions paid on US-domiciled ETFs with exposure to US stocks are subject to withholding tax, depending on the investor’s location.

However, a Europe-domiciled ETF with the same exposure may allow the ETF to claim back part of the withholding tax on fund distributions because of international tax treaties. Further, in Europe, dividends may not always be distributed, but rather reinvested.

For the Mena-based investor, the option of having the dividends reinvested if the dividend income is not needed becomes relevant when choosing the domicile of the ETF to avoid potential taxes.

Therefore, domiciliation becomes an important factor to consider for Mena-based investors to maximise the investment opportunities of the ETF/ETP market.

Alessio Cirillo is the EMEA sales director at Invesco.