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Key Messages:

  • A synthetic ETF may have to invest in performance-linked access products, which are derivatives, to track the performance of an underlying index of a restricted market (e.g. China A-share market).

If the ETF seeks to track the performance of an underlying index of a restricted market, such as the China A-share market, it may have to invest in performance-linked access products (Access Products), which are derivative instruments, in order to replicate the performance of the underlying index.

For example, an ETF adopting a synthetic replication strategy may invest in Access Products linked to securities in substantially the same weightings as those securities in the underlying index. The investment amount will be the net proceeds generated from the issuance of the ETF units, and in return, the Access Products issuer will provide the ETF with an exposure to the economic gain (or loss) in the performance of the underlying index (net of fees, charges and indirect costs, if applicable).

The relationship between the ETF and the Access Products issuers is explained in the diagram below.

The synthetic ETF manager will manage the ETF so that its net exposure to each single counterparty is no more than 10% of the net asset value of the ETF. Where the gross exposure to an Access Product issuer exceeds 10% at the end of each trading day, that Access Product issuer, or its affiliated collateral provider(s) will have to provide collateral to be delivered to/ pledged in favour of the ETF to limit net exposure of the fund to the counterparty risk of the relevant Access Product issuer to no more than 10% of its net asset value (Note).

Therefore, if a synthetic ETF invests in Access Product 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: Effective from 31 October 2011, managers of all domestic synthetic ETFs with collateral arrangements are required to top-up the collateral level for such ETFs to achieve at least 100% collateralization with a view to ensuring there is no uncollateralized counterparty risk exposure arising from the use of financial derivatives to replicate index performance.

These synthetic ETF managers are also required to put in place a prudent haircut policy, in particular, where the collateral taken is in the form of equity securities, the market value of such equity collateral must be equivalent to at least 120% of the related gross counterparty risk exposure.