Oversight January 2017 - Hong Kong opens the door to leveraged and inverse ETFs tracking Hong Kong indices

Introduction

On 23 December 2016, the Securities and Futures Commission of Hong Kong (SFC) published a supplemental circular on leveraged and inverse products (Supplemental Circular) by which the SFC announced that it would begin accepting applications for authorisation of leveraged and inverse products (L&I Products) tracking Hong Kong equity indices and, on a case by case basis, non-equity indices on 9 January 2017.  This significant broadening of permitted scope will see a number of L&I Products launched during the course of 2017.

The Supplemental Circular amends the SFC’s circular on L&I Products dated 5 February 2016 (L&I Circular) which sets out the requirements for L&I Products structured as exchange traded funds (ETFs) listed in Hong Kong and which originally restricted eligible indices to non-Hong Kong and non-Mainland Chinese equity indices. 

This Oversight provides a summary of the circulars relating to L&I Products and an overview of the regime for and recent developments of L&I Products in Hong Kong.

What are L&I Products?

Leveraged ETFs typically aim to deliver a daily return equivalent to a multiple of the underlying index return that they track or, alternatively, track the performance of an index which is itself a leveraged index on an underlying index or benchmark.  

In contrast, inverse ETFs typically aim to deliver the opposite of the daily return of the underlying index that they track or, alternatively, track the performance of an inverse index on an underlying index or benchmark.  The portfolios of L&I Products are typically rebalanced on a daily basis in order to produce the specified leveraged or inverse return.

L&I Products have become increasingly popular in overseas markets in recent years as a trading tool for short term market timing and hedging and have been introduced in a number of Asian markets such as South Korea, Japan and Taiwan for some time.  

Since L&I Products structured as ETFs must be authorised by the SFC under the Securities and Futures Ordinance (SFO) in order to be listed on The Stock Exchange of Hong Kong Limited (SEHK) and marketed to the public in Hong Kong, industry participants had been eagerly awaiting the SFC’s official guidance for L&I Products in order to launch these products in Hong Kong.  The SFC has historically welcomed new ETFs to the SEHK but has been cautious towards L&I Products – reflecting its concerns to protect retail investors.

L&I Circular 

The SFC issued the L&I Circular a year ago on 5 February 2016.  This sets out the requirements under which the SFC would consider authorising L&I Products structured as ETFs for public offering in Hong Kong under the SFO.  In practice L&I Products can only be structured as ETFs.  In order to obtain SFC authorisation, L&I Products must meet the applicable requirements in the Overarching Principles Section and the Code on Unit Trusts and Mutual Funds (UT Code) in the SFC Handbook for Unit Trusts and Mutual Funds, Investment-Linked Assurance Schemes and Unlisted Structured Investment Products, as well as all other additional requirements set out in the L&I Circular and the Frequently Asked Questions on Leveraged and Inverse Products (L&I FAQ) issued by and updated from time to time by the SFC.  

For a summary of the requirements in the L&I Circular and the L&I FAQ, please refer to the Oversight of August 2016 on the regimes for L&I Products in Hong Kong and, by contrast, Singapore.

Given the perceived novelty and technical complexities of L&I Products, the SFC adopted a ‘step by step’ approach to their introduction.  Among other additional requirements, paragraph 10 of the L&I Circular initially restricted the scope of acceptable underlying indices to liquid, broad-based non-Hong Kong, non-Mainland Chinese equity indices, with the express objective to allow time for Hong Kong investors to familiarise themselves with L&I Products and for the SFC to monitor the impact of these products on Hong Kong investors. The SFC indicated that it would conduct a 6-month review after the launch of the initial batch of L&I Products to consider extending eligible indices to include Hong Kong equity indices.

Supplemental Circular

On 23 December 2016, slightly more than 6 months after the launch of Hong Kong’s first ever batch of four L&I Products by Samsung Asset Management on 13 June 2016, the SFC issued the Supplemental Circular announcing that, with effect from 9 January 2017, it would be prepared to accept applications for the authorisation of L&I Products tracking:

• Hong Kong and non-Mainland Chinese foreign equity indices, and 
• on a case by case basis, non-equity indices.

Like other SFC authorised index funds, underlying indices for L&I Products must also comply with the requirements in 8.6(e) of the UT Code, including that the index must be broadly based, sufficiently liquid, transparent and published by an index provider with the necessary expertise and technical resources. 

The SFC pledged to continue to keep in view the eligible indices for L&I Products but repeated that it has no current plan to accept applications for L&I Products tracking Mainland Chinese indices.  This is disappointing to many issuers given such ETFs have operated in other jurisdictions including Taiwan and South Korea for some time.

An updated version of the L&I Circular with the scope of acceptable indices outlined in paragraph 10 amended is enclosed to the Supplemental Circular while all other requirements remain unchanged.  

Implications

The Supplemental Circular was met with interest from industry participants including issuers since L&I Products tracking Hong Kong equity indices are anticipated to attract considerable demand from local retail investors.  Interested issuers had been making preparations for applications well before the Supplemental Circular was released, in the hope of getting a headstart in introducing these Hong Kong-specific products to the market.  

It is likely that the first L&I Products tracking Hong Kong equity indices can be launched as early as the first quarter of 2017, adding to the existing pool of L&I Products listed on the SEHK which track the overseas equity indices such as the S&P 500 Index in the United States and the KOSPI 200 Index in South Korea.  The extension to Hong Kong indices is also likely to attract new managers to enter the L&I Products market, thereby expanding the size of this new market.  Overall this can help bring L&I Products to a wider investor base.  The new L&I Products should also generate trading volume for the SEHK.

The SFC’s indication that it would now consider, on a case-by-case basis, the acceptability of non-equity indices for L&I Products is also an encouraging gesture to managers who wish to put forward more innovative L&I Products for pre-application consultation with the SFC, such as those tracking commodity benchmarks or bond indices.  In recent years a number of precious metals related and oil benchmark ETFs have been listed on the SEHK.

Conclusion

In less than a year’s time since the SFC first allowed the launch of L&I Products in Hong Kong, the city has already witnessed the listing of 12 L&I Products on the SEHK, with a number in the pipeline, demonstrating a growing interest in offering these products to Hong Kong investors.  Given that Hong Kong was relatively late in allowing L&I Products compared to some other Asian markets, there is some ‘catching up’ to do. 

The introduction of Hong Kong focused L&I Products is a welcome development not only for the L&I Products market but also the wider ETF market, and should enhance liquidity in L&I Products as well as ETFs generally.  The release of the Supplemental Circular also suggests that the SFC has, after a 6-month review of L&I Products, formed a favourable view in terms of their market impact as well as the readiness of the investing public for these products.  This suggests that in due course the SFC may also consider expanding the scope of eligible L&I Products not only in terms of the underlying indices but also, for example, the permissible multiple of leverage. 

Shortly after the first batch of L&I Products was launched in Hong Kong, the Monetary Authority of Singapore also published its Frequently Asked Questions on L&I Products on 5 August 2016, which provide guidance for L&I Products structured as funds listed in Singapore.  Competition with Singapore and other markets in the region may provide added incentive to open the doors of the Hong Kong market to a greater variety of ETFs.

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