- Under a funded swap, a synthetic ETF passes on net proceeds from issue of units to a swap counterparty in return for an exposure to the economic gain (or loss) in the performance of the underlying index.
Whether synthetic ETF managers disclose information on collateral or invested assets depends on the types of investments they are involved in with their counterparties. This section explains some common types of investments entered into by synthetic ETF managers with their counterparties in order to replicate the index performance.
Under a funded swap, as illustrated in the diagram below, the synthetic ETF, through the funded swap, will pass on substantially all of the net proceeds generated from the issuance of the ETFs to the swap counterparty, who in return, through the funded swap, will provide the synthetic ETF with an exposure to the economic gain (or loss) in the performances of the underlying indices (net of fees, charges and indirect costs, if applicable).
The synthetic ETF manager will manage the ETF so that its net exposure to each single party is no more than 10% of the net asset value of the ETF. In other words, the net value of the collateral, marked to market at the end of each trading day, shall be no less than 90% of the net asset value of the ETF. Where the ETF's gross exposure to a counterparty exceeds 10% at the end of each trading day, that counterparty will have to provide collateral to be delivered to/ pledged in favour of the ETF to limit net exposure of the fund to that counterparty to no more than 10% of its net asset value (Note).
Therefore, if a synthetic ETF invests in a funded swap when adopting a synthetic replication investment strategy, the ETF manager will be required to disclose the components of the collateral and their top 10 holdings in the collateral on their websites. Such information will have to be updated on a monthly basis.
Note: The new requirement for synthetic ETF managers to top-up a counterparty's collateral level to 100%, which became effective from 31 October 2011 onwards, applies to domestic synthetic ETFs with collateral arrangements primarily regulated by the SFC. Currently all synthetic ETFs listed in Hong Kong that adopt a funded swap structure are overseas synthetic ETFs cross-listed in Hong Kong and in practice, they have complied with the full collateralization requirement.