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Rebalancing of an L&I Product normally takes place daily at the market close in order to achieve its investment objective, i.e. to deliver a multiple or the opposite of the return of its underlying index on a daily basis. However, it may rebalance more frequently than daily, such as when the L&I Product has adopted a stop-loss mechanism and such mechanism is triggered. Some L&I Product issuers adopt stop-loss mechanism to limit the potential loss of the L&I Products at time of extreme market volatility. However, there are circumstances that the daily return of the L&I Products may be lower if such mechanism is adopted. Please refer to the examples below for illustration.

      How does stop-loss mechanism work?

      Leveraged / inverse index (i.e. an index that already incorporates the applicable leverage factor) tracked by the L&I Product may embed stop-loss mechanism. Such mechanism sets a predetermined threshold of movement in the index, typically at a level that is expected to be reached only at time of extreme market volatility (e.g. 25% fall within a trading day). Rebalancing will take place immediately during a trading day when the mechanism is triggered. The leveraged / inverse index will then be reset, back to its target 2x or -1x leverage factor in accordance with the intra-day reset procedure as determined by the index methodologies. The leveraged / inverse index will be rebalanced again at the usual daily rebalancing at the market close so that its leverage factor is maintained at its target level.

      The L&I Products, tracking such leveraged / inverse index with the stop-loss mechanism, will make the following change accordingly:

      • For futures-based L&I Products, the product issuer will rebalance the product's futures contracts portfolio in line with the changes in the leveraged / inverse index, both when the index is reset during the day and at the market close.
      • For swaps-based L&I Products, the swap counterparties will provide the L&I Product with the return of the leveraged / inverse index after incorporating the intra-day reset mechanism. In line with such leveraged / inverse index, the L&I Products will be rebalanced again at the usual daily rebalancing at the market close.

      Examples

      At the start of a trading day, assuming that a futures-based 2x leveraged product's NAV (i.e. index level) is $100, its exposure to the underlying index is twice of its NAV i.e.$200. The stop-loss mechanism will be triggered if the underlying index falls by 25% during a trading day.
      If the underlying index drops by 25% to 75 during a trading day, the 2x leveraged product's NAV will drop to $50 ($100 x (100% - 2 x 25%)) and its exposure to the underlying index will drop to $150 ($200 x (100% - 25%)). As a result, the leverage factor will become 3x ($150/$50).
      The stop-loss mechanism triggered will be reset in accordance with the index providers' intra-day reset procedure. The 2x leveraged product will accordingly rebalance its portfolio by reducing its underlying index exposure by $50 to $100. The leverage factor will be restored to 2x ($100/$50).

       

  • Scenario 1: What happens if the underlying index bounces back by 20% after its initial drop during the remaining of the trading day?
    With the stop-loss mechanism
    (leverage factor: 2x):
    Without the stop-loss mechanism (leverage factor: 3x):
    Underlying index value:
    = 75 x (100% + 20%) = 90

    The 2x leveraged product's exposure:
    = $100 x (100% + 20%) = $120

    The 2x leveraged product's NAV:
    = $50 x (100% + 2 x 20%) = $70

    Daily return of the 2x leveraged product:
    = ($70/$100 - 1) x 100% = -30%
    Underlying index value:
    = 75 x (100% + 20%) = 90

    The 2x leveraged product's exposure:
    = $150 x (100% + 20%) = $180

    The 2x leveraged product's NAV:
    = $50 x (100% + 3 x 20%) = $80

    Daily return of the 2x leveraged product:
    = ($80/$100 - 1) x 100% = -20%



    In cases where the underlying leverage index rebounds after an initial fall that triggers the stop-loss mechanism (where applicable), the daily return of products with stop-loss mechanism may be lower than that of products with no stop-loss mechanism.

  • Scenario 2: What happens if the underlying index continues to fall for another 20% after its initial drop during the remaining of the trading day?
    With the stop-loss mechanism
    (leverage factor: 2x):
    Without the stop-loss mechanism (leverage factor: 3x):
    Underlying index value:
    = 75 x (100% - 20%) = 60

    The 2x leveraged product's exposure:
    = $100 x (100% - 20%) = $80

    The 2x leveraged product's NAV:
    = $50 x (100% - 2 x 20%) = $30

    Daily return of the 2x leveraged product:
    = ($30/$100 - 1) x 100% = -70%

    Underlying index value:
    = 75 x (100% - 20%) = 60

    The 2x leveraged product's exposure:
    = $150 x (100% - 20%) = $120

    The 2x leveraged product's NAV:
    = $50 x (100% - 3 x 20%) = $20

    Daily return of the 2x leveraged product:
    = ($20/$100 - 1) x 100% = -80%




    In cases where the underlying leverage index continues to fall after an initial fall that triggers the stop-loss mechanism (where applicable), the daily return of products with stop-loss mechanism may be higher than that of products with no stop-loss mechanism.

    •  

      The details of the stop-loss mechanism and auto rebalancing, such as the trigger levels, could differ across L&I Products. Also, some L&I Products / indices may rebalance only when the underlying indices either rise or fall by a certain percentage. Please refer to the offering documents of the L&I Products for details.

      What are the implications of stop-loss mechanism?

      • Stop-loss mechanism tracking error risk:
        When the stop-loss mechanism is triggered on a given business day, the L&I Product may not be able to deliver a daily return equivalent to a multiple or the opposite of the daily return of the (non-leveraged non-inverse) underlying index.
      • Gain limitation risk: The rebalancing resulted from the stop-loss mechanism would restore the leverage factor of an L&I Product, back to its target 2x or -1x level. The leverage factor would thus be smaller in absolute term compared to such multiple or opposite of the daily return of the underlying index when no stop-loss mechanism is triggered. If the performance of the underlying index reverses during the remaining of trading day after the stop-loss mechanism is triggered, investors of the L&I Products may not be able to capture the gain from the reversal of the underlying index return to the same extent that they may have if the stop-loss mechanism had not been adopted.