Hong Kong regulator approves short and leveraged ETFs

Mar 8th, 2016 | By | Category: Alternatives / Multi-Asset

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The Securities and Futures Commission (SFC), Hong Kong’s financial markets regulator, has authorized the issuance of leveraged and inverse exchange-traded funds. The move follows a report in October last year from Hong Kong’s Financial Services Development Council (FSDC) detailing concerns over the territory’s ETF market falling behind the likes of Mainland China, Taiwan, Singapore and South Korea.

Hong Kong regulators approve short and leveraged ETFs

The authorization of inverse and leveraged ETFs in Hong Kong (pictured) seeks to align the city’s practices with those of its regional competitors.

Leveraged ETFs magnify exposure to an underlying index, while inverse ETFs profit from a decline in an underlying index. The funds use derivatives to obtain their respective exposures and are required to re-balance their positions on a daily basis.

The move seeks to align the territory’s ETF segment more closely with its counterparts in Mainland China, Japan, South Korea, Singapore and Taiwan. The FSDC report noted that Hong Kong’s position as leader in the ETF market had been overtaken by Japan and Shanghai, who have introduced more innovative products.

South Korea was the first Asian market to launch inverse and leveraged ETFs about five years ago, although subsequent growth patterns has seen Japan become the regional leader for alternative ETFs. The FSDC’s report shows data that from 2006 to 2015 Hong Kong only saw a modest 6% increase in its portion of ETF Asian assets. This compares to an increase in Mainland China of 25% and Japan of 36% over the same period.

Most recently Taiwan rolled out their first inverse and leveraged ETFs. In October 2014 – the Yuanta Daily Taiwan 50 Bull 2X ETF and the Yuanta Daily Taiwan 50 Bear -1 ETF were launched. During 2015, the country welcomed two new alternative ETFs, the Fubon Topix Leveraged 2X Index ETF and the Fubon Topix Inverse -1X Index ETF, providing leveraged and inverse exposure to Japan’s TOPIX Index. The launch was indicative of a regional desire to further integrate Asian capital markets.

While inverse and leveraged funds provide an efficient means for sophisticated traders to obtain tactical exposures, they have come under scrutiny on several occasions. The funds have been labelled unsuitable for retail investors who may not fully understand the risks involved, such as the potential for considerable losses in volatile but range bound markets if the fund is held for an extended period.

The controversy surrounding these products has in fact led the US Securities and Exchange Commission to propose a cap on the leverage provided by these products through derivatives (150% of the fund’s net assets). If enacted, these new rules could force the closure of a significant number of US-listed leveraged ETFs.

Due to the potential risks associated with these products, the SFC has published a circular highlighting specific requirements for future launches of inverse and leveraged ETFs. The circular’s stated aim is to “protect the interests of the investing public of Hong Kong”.

Similarly, the FSDC report strongly suggests that education is the most important factor in the region’s ETF market. “Investor education is an important aspect for the development of ETFs in Hong Kong.  The strategy of using ETFs as a low cost way to implement a strategic asset allocation is not well‐known or commonly used among Hong Kong investors/advisors. For a business to grow, the prerequisite is for there to be a demand for the business.   Hence, it is important to ensure that investors are aware of the benefits and the needs in investing in ETFs……We recommend a joint effort by ETF issuers, distributors, the SFC, the SEHK and the government to be made to promote investor education on ETFs.”

Requirements for the new ETFs include an initial limit to a factor of two for leveraged ETFs while inverse leveraged funds are currently still prohibited. Furthermore, in an effort to curb any negative effects on local equity markets, for an initial six months these products may only be based on highly liquid and broadly based non-Hong Kong, non-Mainland foreign equity indices, pending an initial review of the funds’ impact.

Strict disclosure and naming requirements shall also be enforced to minimize the risk that investors are not fully aware of the implications of magnified returns and daily re-balancing. Additionally, at least one market maker must be designated at all times for each product with potential candidates undergoing vetting processes.

Following the announcement, a number of issuers are believed to be finalizing plans future launches of leveraged and inverse ETFs.

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