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Note to investors:

The UCITS III Directive has significantly expanded the range of permissible investments for UCITS funds and provided more investment flexibility by permitting investments in financial derivative instruments ("FDIs").

UCITS III funds may use FDIs extensively or primarily for investment purposes. Please refer to the offering documents for details.

The use of FDIs for investment purposes involves special risks such as counterparty risk, valuation risk and liquidity risk. In some cases, the use of FDIs may increase the volatility of a fund or magnify investment losses.

UCITS III funds have different risk profiles and features. Not all UCITS III funds use FDIs for investment purposes. You may refer to the SFC's website on investment products for those SFC authorised UCITS III funds which may invest in FDIs.

It is important that you understand a fund's investment objective and strategy. Pay special attention to the investment risks of a UCITS III fund and make sure that you can accept the risks before investing into the fund. Please read the offering documents and notices relating to each of your fund investments very carefully. If you are in any doubt, please do not hesitate to consult with and seek advice from the fund manager or the Hong Kong representative of your fund or your intermediary.

    UCITS III

  • In general terms, what is UCITS III?

    Broadly speaking, UCITS III is a set of legislation adopted by the EU Commission1 regulating many investment funds from the EU member states2. In essence, its main objectives are to widen the range of investment possibilities and assist the cross-border marketing of funds throughout Europe. Under UCITS III, funds may use FDIs for investment purposes (and not just for hedging or efficient portfolio management purposes).

    Funds domiciled in the EU member states and established under the previous regulatory framework known as UCITS I were required to be compliant with the UCITS III regulations by February 2007. Many of the SFC authorised funds are UCITS III funds and thus affected by these regulations.

    UCITS III regulations apply to UCITS funds which are domiciled within the EU member states only. Where a fund invests in European markets or is managed by a European fund manager, it does not necessarily mean that it is affected by UCITS III regulations. You should check the domicile and type of your fund to see if it is affected by the regulations. The domicile and type of your fund is disclosed in the offering document.

  • What changes have been brought to my fund investments following the implementation of UCITS III regulations?

    In terms of investment strategy, UCITS III regulations give UCITS funds domiciled in EU member states2 more investment flexibility by expanding the range and type of permissible financial instruments such as transferable securities and money market instruments, bank deposits, units of other investment funds, FDIs and index tracking funds. However, it is up to the fund manager of each fund to decide whether to utilize such investment flexibility or not and the extent of utilization.

    Each fund is unique and you should therefore read the latest offering document of a UCITS III fund carefully regarding the extent to which the fund's investment strategy may utilise the expanded investment powers, paying particular attention to the fund's investment objectives, policies, risk factors and strategies, if applicable.

  • Is it more risky to invest in UCITS III funds? Do UCITS III funds provide higher returns? What other factors should I consider before investing in UCITS III funds?

    It is difficult to say whether UCITS III funds will attract higher return or more risks. Regardless of whether the fund is a UCITS III fund or not, you should always read the fund's offering document carefully before making any investment decision. In particular, you should consider whether the fund's investment objective and risk profile is within your own investment needs and risk tolerance. You should also seek financial and other professional advice if necessary. Investment involves risks. The fund is subject to the risks inherent in its investments and the value of your fund may go up as well as down.

  • I am an existing holder of a UCITS III fund. How can I know if my fund may use FDIs extensively or primarily for investment purposes?

    You should refer to the latest offering document of the fund, in particular the sections on the fund's investment objectives, policies, restrictions and risk factors. A UCITS III fund which invests in FDIs is generally required to clearly disclose this fact in its investment policies and the investment risks associated with the FDIs involved. The fund is also required to provide a description of the related risk management processes.

    You may also refer to the SFC's website on investment products, which shows a list of SFC authorised funds that are UCITS III funds. UCITS III funds may use FDIs extensively or primarily for investment purposes. Please refer to the offering document of the relevant fund for details and consult with and seek advice from the fund manager or the Hong Kong representative of your fund or your intermediary.

  • My fund does not intend to invest in FDIs based on its current offering document. Can it change its mind later and use the powers? Will I be notified of the change or given the opportunity to vote for or against it?

    Yes, the fund manager can change its mind to use the expanded investment powers at a later stage. In general, you may receive a notice requesting your vote on the use of expanded investment powers, or a letter notifying you of their intention to expand the fund's investment power. Please read that notice or letter carefully. It will contain information such as the key changes in the fund's investments after the conversion and the additional risks associated with the use of expanded investment powers, if any.

  • Will my existing asset allocation in my investment portfolio be affected if my fund chooses to utilise the expanded investment powers under the UCITS III regulations?

    If your fund chooses to take up the expanded investment powers allowed under the UCITS III regulations, the types of investments underlying your fund may change and the overall asset allocation of your own investment portfolio may thus be affected. You should read any notices that you may receive about the conversion and the revised offering document of your fund carefully.

  • What are the differences in using FDIs for hedging/investment purposes?

    Hedging by way of FDIs generally refers to the use of FDIs with a view to reducing the risks of adverse price movements in an asset or a portfolio. However, the use of FDIs by the UCITS III funds for hedging purposes may not be effective. Therefore, there is no guarantee that the risks of adverse price movements in an asset or a portfolio can be reduced from the use of FDIs for hedging purposes. On the other hand, using FDIs for investment purposes is not intended to "reduce" the risks of adverse price movements in an asset or portfolio, but rather to fulfil the investment objective of a fund or to generate further gains for the fund, which may attract additional risks (e.g. market risk, leverage risk, valuation risk, liquidity risks, etc).

    The use of FDIs by the UCITS III funds for hedging/ investment purposes is a highly complex matter. Please refer to the offering document of the relevant fund for details and consult with and seek advice from the fund manager or the Hong Kong representative of your fund or your intermediary.

  • Will all UCITS III funds use FDIs for investment purposes? What are the benefits of using FDIs for investment purposes?

    Not all UCITS III funds will utilise the expanded investment flexibilities permissible under the UCITS III regulations or use FDIs for investment purposes. It is up to the fund manager, taking into consideration of the investment objective of a fund and the risk management processes at its disposal, to decide whether to utilise the investment flexibility or not. Hence, different UCITS III funds may have different exposures to FDIs.

    The use of FDIs may allow a fund manager greater flexibility or cost savings in achieving the intended investment objective of a fund. However, the use of such instruments are required to be subject to compliance with the investment restrictions under the UCITS III regulations and the requirements on risk management.

    Investors should always pay attention to the investment risks associated with the use of FDIs of a UCITS III fund (See next FAQ).

  • What are the risks of engaging FDIs in a fund's investment strategy?

    Depending on the type of FDIs used, a fund could potentially be exposed to additional risks and losses should the market move against it. The use of FDIs involves special risks such as counterparty risk, valuation risk and liquidity risk. In some cases, the use of FDIs may increase the volatility of a fund/magnify or increase investment losses. For example, as the value of a security could theoretically rise exponentially, a fund which uses FDIs to gain a short exposure to such a security could suffer losses exceeding the value initially invested by the fund in such FDIs should the value of the security rise.

  • Are UCITS III funds suitable for me? What do I have to pay attention to before investment in a UCITS III fund?

    The UCITS III regulations provide more investment flexibility to a fund such as the use of FDIs for investment purposes. The investment strategy and the risks inherent in a UCITS III fund utilising such flexibility are different from those typically encountered in a traditional equity long only fund. See FAQ #9 for possible additional risks.

    You should therefore pay special attention to the risks involved in a UCITS III fund and ensure that you can accept the risks before investing into the fund. It is important that you read the offering document carefully and consider whether the fund's investment objective and risk profile match your investment needs and risk tolerance. You should seek financial and other professional advice, if necessary.

  • Different approaches for calculating leverage level

  • In general, UCITS funds using FDIs extensively for investment purposes and applying Value-at-Risk (VaR) approach to monitor risk may disclose their leverage level via FDIs by using (1) the sum of notionals approach and (2) the commitment approach. What are the differences between these two approaches?

    Leverage level via FDIs of UCITS funds is generally calculated according to two approaches: (1) the sum of notionals approach and (2) the commitment approach.

    • The level of leverage using the sum of notionals approach is expressed as a ratio between the aggregate of the notional values of all FDIs entered into by the fund (including FDIs that are used for investment purposes and/or for hedging purposes) and its net asset value. This approach does not allow the netting of FDI positions and include the level of exposure to the underlying assets of the FDIs used for hedging purposes.
    • The level of leverage using the commitment approach is expressed as a ratio between the market value of the equivalent position in the underlying assets of the FDIs (excluding FDI positions for hedging purposes) and its net asset value. This approach allows netting of certain FDI positions (subject to specified conditions).

    In general, level of leverage expressed using the commitment approach is lower than that expressed using the sum of notionals approach as it takes into account the netting and hedging arrangements. Please see below illustrative examples demonstrating the level of leverage using the sum of notionals approach and the commitment approach for funds using FDIs for different purposes.

    Illustrative examples

  • How would leverage resulted from using FDIs affect investors?

    Due to the leverage effect of FDIs, the gains and losses derived from FDIs will be magnified at the fund level. While FDIs may allow a fund to earn higher returns from small movements in the underlying asset's price, the fund could also lose large amounts if the price of the underlying moves against them. For a fund using more FDIs with a higher leverage level, the value of the fund could be more volatile as a small movement of the price of the FDI’s underlying asset would lead to a large movement in value of the FDI and hence the net asset value of the fund. In adverse situations, leverage from using FDIs may result in very substantial and even total loss of a fund’s assets in a short period of time.

  • How to find out the level of leverage of an SFC-authorised UCITS fund that uses FDIs extensively for investment purposes?

    For an SFC-authorised UCITS fund that uses FDIs extensively for investment purposes, you can find out the information on the level of leverage as a result of the use of FDIs and the corresponding calculation basis in the offering documents (including the Products Key Facts Statement) of the fund.

  • 130/30 funds under UCITS III

  • What is the key feature of a 130/30 fund?

    In essence, a 130/30 fund employs an equity long-short strategy. The intended fund portfolio will combine long positions with a total value of 130% of the net asset value of the portfolio and short positions with a value of 30% of the portfolio, resulting in a net market exposure of 100%. "Long" generally refers to the purchase of a security, expecting its price to rise, while "short" refers to the sale of a borrowed security, expecting its price to fall (i.e. the principle of selling high and (later) buying back low). The proceeds from the short positions are used to acquire the additional long positions.

    It should be noted that a 130/30 fund will generally utilise the expanded investment powers under UCITS III. It will seek to use FDIs such as futures, forwards, swaps and options, to get its short exposure for investment purposes.

  • What are the differences between a 130/30 fund and a hedge fund?

    A UCITS III fund structured as a 130/30 fund must comply with the quantitative and other limits set out in the UCITS III regulations, including the requirement that the net market exposure of the fund must not exceed its net asset value, the counterparty exposure limits, the restrictions on assets which may form the underlying of the financial derivative contracts, the borrowing limit, and the general requirement that the use of FDIs will not cause the fund to diverge from its investment objectives.

    While a hedge fund may seek to implement an investment strategy similar to 130/30, it is not subject to the UCITS III regulations such as exposure or borrowing limits mentioned above.

  • What are the risks associated with a 130/30 fund? Will it be more risky than a traditional equity long only fund?

    You should note that the investment strategy and risks inherent in a 130/30 fund are not typically encountered in a traditional equity long only fund. A 130/30 fund will normally use derivatives as part of its investment strategy and such investments are inherently volatile. The fund could potentially be exposed to additional risks and losses should the market move against it.

    As a 130/30 fund may use FDIs to take short positions in some securities, should the value of such securities increase, it will have a negative impact on the fund's value. In extreme market conditions, the fund may be exposed to theoretically unlimited losses. This could mean that you could, in certain circumstances, face minimal or no returns, or may even suffer a loss.

  • Replication of hedge fund indices

  • I am interested in investing in a UCITS III fund which aims to seek returns that generally follow the performance of a hedge fund index by adopting a synthetic replication model. How does the model work?

    As the term "synthetic replication" implies, such UCITS III fund generally will not invest directly in any hedge funds or the constituents of the hedge fund index. It aims to provide investors with a return linked to the performance of the hedge fund index through alternative strategies/models. For example, a model may seek to achieve similar performance of a hedge fund index by taking long and/or short positions in different asset classes of equities, debts, commodities and currencies, where the position weight for each asset class is determined based on statistical correlation between the past performance of the hedge fund index and that of the asset class concerned.

    The fund may then use FDIs, such as entering into an over-the-counter ("OTC") swap with a counterparty, to gain exposure to the potential returns generated by the synthetic replication model.

    It should be noted that the returns so replicated do not necessarily reflect the actual returns of the underlying hedge fund index due to tracking errors and/or other factors.

    Each synthetic replication model may differ in the mechanics as to how it would achieve its replication objective. Investors should refer to the fund's offering documents for a detailed description of the methodology employed.

  • What are the key risk factors that I have to consider before investing in that fund (as described above)?

    Some of the more prominent risk factors are:

    • Risks associated with the hedge fund industry - Although the fund does not directly invest in hedge funds, its potential performance is designed to closely correlate to the performance of the hedge fund index that represents the hedge fund industry. It should be noted that private hedge funds are generally not subject to regulation in terms of investment restrictions and risk diversification. In addition, they may employ leverage and engage in short selling as well as other alternative investment strategies, leading to higher volatility and potential losses.
    • Tracking errors - Depending on its design and features, a synthetic replication model may have limited capability to react in response to market changes, e.g. reaction time lag. Therefore, changes in the net asset value of the fund are unlikely to replicate exactly the performance changes of the underlying hedge fund index of the model.
    • Lack of discretion of the investment manager to adapt to market changes - The fund is not "actively managed". The investment manager of the fund generally will not adjust the composition of the fund's portfolio to seek temporary defensive positions even if the performance of the underlying hedge fund index declines or when the hedge fund sector is considered to be overvalued.
    • Use of FDIs - It is possible that the fund may use FDIs, such as OTC swaps, to seek exposure to the potential returns generated by the synthetic replication model. The use of FDIs involves additional risks such as counterparty risk, valuation risk and liquidity risk.

    Investors should pay special attention to the sections of investment policy/objective and risk factors in the fund's offering documents before investing.

1 EU Commission stands for European Union Commission.

2 EU stands for European Union. As of 31 August 2007, EU member states include: Austria, Belgium, Bulgaria, Cyprus, Czech Republic, Denmark, Estonia, Finland, France, Germany, Greece, Hungary, Ireland, Italy, Latvia, Lithuania, Luxembourg, Malta, Netherlands, Poland, Portugal, Romania, Slovakia, Slovenia, Spain, Sweden and the UK.