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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 of or the multiple of 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, -1x or -2x 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 of or the multiple of 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, -1x or -2x level. The leverage factor would thus be smaller in absolute term compared to such multiple of or such multiple of the 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.


8 May 2019