Oversight August 2016 - Leveraged and inverse ETFs in Hong Kong and Singapore

Introduction

On 5 February 2016, the Securities and Futures Commission in Hong Kong (SFC) published a circular on leveraged and inverse products (SFC Circular) which sets out the requirements of leveraged and inverse products (L&I Products) structured as exchange traded funds (ETFs) listed in Hong Kong. 

Shortly after the first batch of L&I Products was authorised by the SFC and launched in Hong Kong in June 2016, the Monetary Authority of Singapore (MAS) on 5 August 2016 published its Frequently Asked Questions on L&I Products (MAS FAQ) which provide guidance for L&I Products structured as funds listed in Singapore.

This Oversight provides a brief summary of and a comparison between the regimes for L&I Products in Hong Kong and Singapore.

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.  For example, if the underlying tracked index rises by 10% on a given day, a two-time (2x) leveraged ETF aims to deliver a 20% increase on that day. Alternatively, leveraged ETFs can track the performance of an index which is itself a leveraged index on an underlying index or benchmark.

Inverse ETFs, by contrast, typically aim to deliver the opposite of the daily return of the underlying index that they track.  For example, if the underlying tracked index rises by 10% on a given day, a one-time (-1x) inverse ETF aims to deliver a 10% decline on that day. Again, inverse ETFs can 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.

Requirements in Hong Kong

L&I Products must be collective investment schemes authorized by the SFC under the Securities and Futures Ordinance (SFO).  This allows L&I Products to be listed on The Stock Exchange of Hong Kong Limited (SEHK) and marketed to the public in Hong Kong.  

In order to obtain the SFC authorisation, apart from meeting 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, L&I Products must also satisfy the additional requirements set out in the SFC Circular and the Frequently Asked Questions on Leveraged and Inverse Products (SFC FAQ) issued by the SFC.

Product naming

Although L&I Products are ETFs which track the leveraged or inverse performance of an index, to avoid confusion with more traditional ETFs the SFC does not allow them to be named as “ETFs” but requires them to be called “Leveraged Products” or “Inverse Products” instead. The name also always has to include the leverage/inverse factor (i.e. x1 or x2, etc) and the word “daily” to emphasise the daily rebalancing.  For example, a one-time inverse ETF should be named “[Issuer name] [Index name] Daily (-1x) Inverse Product”. 

Additional requirements are imposed on swap-based L&I Products, e.g. they are required to put an asterisk () and an annotation in English “(\This is a synthetic product)” and in Chinese “(*此產品為一隻合成產品)”, as the case may be, after their name whenever this appears in offering documents and marketing materials.  This is similar to the longstanding convention in Hong Kong applicable to synthetic ETFs.

L&I Products are also placed in a new and standalone product category on both the websites of the SFC and Hong Kong Exchanges and Clearing Limited (HKEx), with distinctive stock short names beginning with an “L” for leveraged ETFs and an “I” for inverse ETFs. 

These measures aim to ensure that L&I Products are considered a distinct asset class, and that prospective investors understand the risks involved before investing.  

Product structure

Issuers may adopt either a swap-based synthetic replication strategy or a futures-based replication strategy when structuring the relevant L&I Products.  Although the SFC will authorise both futures-based and synthetic L&I Products, different requirements apply reflecting the relevant structure.  

Initially, the SFC has decided that the maximum leverage factor of leveraged ETFs is capped at two times (2x) and the maximum inverse factor of inverse ETFs is capped at one-time (1x).    

Like all ETFs listed on the SEHK, L&I Products can be established as single funds or as sub-funds of an umbrella fund.  However, whilst L&I Products adopting different replication strategies (e.g. swap-based or futures-based) can be established under the same umbrella, the SFC’s view is that L&I Products have different risk profiles from unlisted funds and conventional ETFs and are required to adopt a different naming convention, the SFC does not expect L&I Products to be established under the same umbrella fund as other SFC-authorised unlisted funds and ETFs.

Underlying index

Given the novelty of L&I Products, the SFC currently only accepts applications for L&I Products tracking liquid and broadly based non-Hong Kong and non-Mainland Chinese foreign equity indices.  The SFC will conduct a review in six months after the launch of the initial batch of L&I Products (anticipated to be in December 2016), and may consider extending the eligible indices to Hong Kong equity indices.  The SFC has no current plan to accept applications for L&I Products tracking Mainland Chinese indices.  It is possible in due course that commodity benchmarks or indices may be used for L&I Products.

Experience of fund manager 

In relation to futures-based L&I Products, the fund manager (and, if applicable, the investment adviser where the latter has been delegated the investment management function (Delegate)) must satisfy the SFC that it has specific experience in the field of futures and options.  This has always been a requirement under the UT Code.

In determining whether or not a fund manager has enough experience, the SFC may also consider the qualifications and experience of the persons employed by the fund manager or the Delegate (if any). It is expected that the fund manager or the Delegate employs staff that have substantive and satisfactory experience (for example, over two to three years’ recent experience) in managing either:

• futures funds that are offered to the public, or
• public funds that use futures extensively for investments purposes. 

In the case of a Hong Kong based manager (which would hold a Type 9 (asset management) regulated activity license from the SFC), those employees would also need to be (i) based in Hong Kong (on a full licence basis) and (ii) licensed representatives under the SFO.

Where a Delegate is appointed, the SFC also expects that: 

• the delegation arrangement should have a minimum duration of two years, and 
• there is a detailed plan to allow the fund manager to acquire specialist expertise in managing futures-based L&I Products for the two-year period during which the investment management functions are delegated to the Delegate. The plan must be to the SFC’s satisfaction. 

Disclosure in offering document

In order to prevent investors from assuming that L&I Products share the buy-to-hold characteristics of conventional ETFs, the SFC requires the offering documents relating to L&I Products to contain certain specific disclosures:

• a warning against holding for longer than the rebalancing interval (typically one day)
• L&I Products are designed as a trading tool for short-term market timing or hedging purposes but not intended for long-term investment
• L&I Products are only suitable for sophisticated trading-oriented investors who constantly monitor the performance of their holdings on a daily basis, and
• the performance of L&I Products, when held overnight, may deviate from the underlying indices. 

In particular, for L&I Products adopting swap-based synthetic replication structures, the SFC requires disclosure of the maximum redemption fee and the costs of entering into the swap with the counterparty, and costs of unwinding the swap (if any).  These must be included in the relevant L&I Product’s prospectus.

In addition to the above, the standard detailed disclosure obligations of the standard disclosure obligations of the UT Code and SFC FAQs also must be complied with.

Market making requirements

At the commencement of trading and on an ongoing basis, at least one market maker is required for a L&I Product.  The HKEx also requires the market maker to possess at least one year of official market making experience in relation to L&I Products. 

Due to the short-term trading nature of L&I Products, the SFC places importance on the ability of investors to enter into and exit their investments.  In the event of resignations of all market makers, a L&I Product must be terminated at about the same time as the effective resignation time of the last market maker. By comparison, there is no such explicit requirement for conventional ETFs although it is always a requirement that the fund manager ensures there is always at least one market maker per counter and that at least one market maker must give not less than 90 days notice before it ceases its market making activities. 

Performance simulator

To demonstrate the performance of the L&I Products under different market conditions, the SFC requires the L&I Products provider to make available a “performance simulator”, allowing investors to simulate the performance of the L&I Product by selecting a historical time period. 

The performance simulator should display the following minimum information: 

• the performance of the L&I Product, measured by its net asset value, and 
• the performance of the non-leveraged, non-inverse version of the underlying index tracked by the L&I Product. 

Disclosure of tracking difference, tracking error, ongoing charges and past performance

Due to the day trading nature of L&I Products and L&I Products’ objective of delivering a multiple or the opposite of the return of their underlying indices only on a daily basis, the SFC requires tracking differences be considered over one-day periods (i.e. daily tracking differences), as opposed to over a longer period of time (typically one year) for ETFs.  The SFC further requires that tracking error be measured by the standard deviation of the daily tracking difference.  The SFC has set out in the FAQ detailed explanations on how tracking difference and tracking error of L&I Products should be calculated and presented.

For the same reason, the annual average daily ongoing charges figure (in addition to ongoing charges figure which is required to be disclosed in the product key facts statements (KFS) of all SFC authorised funds) should also be disclosed in the KFS for each L&I Product.

Given an L&I Product’s objective of delivering a multiple or the opposite of the return of its underlying index on a daily basis or tracking a leveraged/inverse index, the SFC requires the benchmark to be disclosed in the presentation of past performance information for the L&I Product, ie: 

• the non-leveraged and non-inverse version of the underlying index tracked by the L&I Product, and 
• if the L&I Product tracks a leveraged or inverse index, the leveraged (for leveraged products) or inverse (for inverse products) index tracked by the L&I Product. 

Margin financing

In view of the leveraged or inverse features of L&I Products and the additional leverage impact from margin financing, HKEx has advised HKEx participants not to provide margin financing to investors for any trading of L&I Products on the SEHK.

Requirements in Singapore

In order for L&I Products to be offered to retail investors in Singapore, the L&I Products have to comply with the MAS FAQ, as well as the authorisation/recognition and disclosure requirements for collective investment schemes set out in the Securities and Futures Act (Chapter 289 of Singapore) (SFA), the Securities and Futures (Offers of Investments) (Collective Investment Schemes) Regulations 2005 (SFR) and the Code on Collective Investment Schemes (CIS Code), including Appendices 1 and 5 of the CIS Code. 

Product naming

Similar to Hong Kong, the MAS requires the name of L&I Products not to contain the term “ETF”, or any other derivative or form of such term. Like Hong Kong, Singapore also requires that the leverage/inverse factor, the leverage/inverse feature and the daily performance reset feature be evident in the name of the L&I Product. 

L&I Products should also have a distinguishing marker on the trading platform of Singapore Exchange Securities Trading Limited (SGX). 

Product structure

An L&I Product may utilise any of the investment strategies set out in Appendix 5 of the CIS Code, including:

• a full replication by investing all or substantially all of its assets in the constituents of the underlying index, broadly in proportion to the respective weightings of the constituents in the index
• an optimisation approach by investing in a portfolio featuring high correlation to the index to minimise index tracking error
• a sampling approach by stratifying or dividing an index into manageable risk elements or buckets to replicate the underlying index performance, and
• a synthetic replication through the use of financial derivatives or embedded financial derivatives to replicate the index performance.

To facilitate better understanding of L&I Products, the MAS expects fund managers to adopt a phased approach when developing and offering such products to investors by beginning with lower leverage/inverse factors. Unlike under the present SFC Circular for Hong Kong, in Singapore the maximum leverage factor of L&I Products is presently capped at two times (2x) although where the L&I Product exhibits more novel characteristics or provides a high leverage factor (such as one that targets a return of three times or more of the returns of the underlying index on a daily basis), the MAS should first be consulted.

L&I Products may track any underlying index that complies with Appendix 5 of the CIS Code and is not an inverse Mainland-China index. In Hong Kong, under the UT Code, the index must be acceptable to the SFC and at present, Mainland Chinese indices (whether leveraged or inverse) are not permitted for L&I Products.

Fund manager

Fund managers who do not have a Capital Markets Services licence in Singapore can consider the following models to list L/I Products in Singapore:

• become a sub-manager for a local L&I Product listing
• form a joint venture with a local fund manager
• white-label an existing L&I Product to a local fund manager, and
• develop a feeder fund structure which will feed into an existing L&I Product.

Disclosure in offering document

In addition to the usual disclosure requirements under the SFA, SFR and the CIS Code, the MAS FAQ requires the offering document and product highlights sheet (the Singapore equivalent of the KFS in Hong Kong) of an L&I Product to also contain the following:

• a box for important information to facilitate investors’ assessment of the unique daily reset features and the difference in risk profile of the L&I Product as compared to traditional ETFs. The box should feature prominently before the specific disclosure on the investment objective of the L/I Product
• the information in the box should stress that the L&I Product is meant for sophisticated investors who manage their portfolios on a daily basis and that it is not appropriate for long term investment
• prominent disclosures that the L&I Product may be completely uncorrelated to the percentage change of the relevant underlying index over a period beyond one day, especially in periods of volatility, and
• further explanations of how the performance of the L&I Product may vary from the returns of the relevant underlying index for periods longer than a day. The use of diagrams such as tables and graphs is encouraged.

On paper at least, the MAS requirements are fairly similar to those in Hong Kong.

Comparison of Hong Kong’s and Singapore’s L&I Products

Conclusion

ETFs are growing in popularity in Asia. Globally ETF assets under management (AUM) stood at USD 3.177 trillion as at 30 June 2016. In July 2015, the global ETF’s AUM for the first time was estimated to have exceeded global AUM for hedge funds. 

The SEHK is the eighth largest stock exchange of the world in terms of market capitalisation, and the third largest stock exchange in Asia in terms of ETF AUM (USD 38.3 million) and ETF turnover (USD 253.4 billion) as at 31 December 2015. However, the Hong Kong ETF market is still very small compared with that of the United States which has an AUM of approximately USD 2 trillion. L&I Products are a welcome addition to the ETF offering on the SEHK and will allow Hong Kong to compete with Korea in developing these products.

SGX has introduced a number of incentives to aid ETF liquidity and encourage new products in Singapore. SGX is waiving fees for ETF trade reporting and clearing on SGX until 31 December 2017. It is also excluding all cash-replicated ETFs from the MAS’s complex products regime (SIP regime) which means such ETFs will be fully accessible to all investors (including retail investors) and endorsable by SGX through its marketing and educational tools. In April 2016 the MAS eased rules allowing financial advisers to facilitate the buying and selling of ETFs for their retail clients if such dealing is incidental to their financial advisory activities. Previously, financial advisers (approximately 50 firms in Singapore) could only advise clients to buy ETFs from brokers, instead of directly helping them with the transaction through a platform. 

The introduction of L&I Products in Hong Kong and Singapore should enhance the competitiveness of both Hong Kong and Singapore as a location for product manufacture and innovation. Both jurisdictions have an established ETF legal and regulating infrastructure and the initiatives by the SFC and the MAS (which in many ways are similar) should lead to the listing of many L&I Products on the SEHK and the SGX.

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