1. Introduction to ETF
Exchange Traded Funds (ETFs) are passively-managed and open-ended funds, which are traded on the securities market of Hong Kong Exchanges and Clearing Limited (HKEX). All listed ETFs are authorized by the Securities and Futures Commission (SFC) as collective investment schemes. ETFs are designed to track the performance of their underlying benchmarks (e.g. an index, a commodity such as gold, etc) and offer investors an efficient way to obtain cost-effective exposure to a wide range of underlying market themes. Like other securities, investors can buy or sell ETFs through their brokers anytime during the securities market's trading hours.
ETFs can be broadly grouped into two types:
(a) Physical ETFs (i.e. traditional or in-specie ETFs)
Many of these ETFs directly buy all the assets needed to replicate the composition and weighting of their benchmark (e.g. constituents of a stock index). However, some only buy a portion of the assets needed to replicate the benchmark or assets which have a high degree of correlation with the underlying benchmark but are not part of it. Some physical ETFs with underlying equity-based indices may also invest partially in futures and options contracts. Investors should read the ETF prospectus carefully to ensure they understand how the fund operates.
(b) Synthetic ETFs
These ETFs do not buy the assets in their benchmark. Instead, they typically invest in financial derivative instruments to replicate the benchmark's performance. The ETFs are required to be fully collateralized when investing in derivatives (details of the net and gross counterparty exposure and types and composition of the collateral are published on the ETF's website). Investors should read the ETF prospectus carefully to ensure they understand how the fund operates.
2. Major risks
|Issuer's Risk||Synthetic ETFs typically invest in over-the-counter derivatives issued by counterparties to track an index's performance. Such a synthetic ETF may suffer losses potentially equal to the full value of the derivatives issued by the counterparty upon its default. Synthetic ETFs are therefore exposed to both the risks of the securities that constitute the index as well as the credit risk of the counterparty that issues the financial derivative instruments for replicating the performance of the index.|
|Foreign exchange risk||Investors trading ETFs with underlying assets not denominated in Hong Kong dollars are also exposed to exchange rate risk. Currency rate fluctuations can adversely affect the underlying asset value, also affecting the ETF price.|
|Counterpart Risk involved in ETFs with different replication strategies||
Full replication and representative sampling strategies
An ETF using a full replication strategy generally aims to invest in all constituent stocks/assets in the same weightings as its benchmark. ETFs adopting a representative sampling strategy will invest in some, but not all of the relevant constituent stocks/assets. For ETFs that invest directly in the underlying assets rather than through synthetic instruments issued by third parties, counterparty risk tends to be less of concern.
Synthetic replication strategies
ETFs utilizing a synthetic replication strategy use swaps or other derivative instruments to gain exposure to a benchmark. Currently, synthetic replication ETFs can be further categorized into two forms:
(a) Swap-based ETFs
i. Total return swaps allow ETF managers to replicate the benchmark performance of ETFs without purchasing the underlying assets.
ii. Swap-based ETFs are exposed to counterparty risk of the swap dealers and may suffer losses if such dealers default or fail to honor their contractual commitments.
(b) Derivative embedded ETFs
i. ETF managers may synthetically replicate the economic benefit of the relevant benchmark using other derivative instruments. These instruments may be issued by one or multiple issuers.
ii. Derivative embedded ETFs would expose to counterparty risk of the instruments' issuers and may suffer losses if such issuers default.
|Tracking errors risk||Tracking errors refer to the disparity in performance between an ETF and its underlying index/assets. Tracking errors can arise due to factors such as the impact of transaction fees and expenses incurred to the ETF, changes in composition of the underlying index/assets, and the ETF manager's replication strategy.|
|Trading at discount or premium risk||An ETF may be traded at a discount or premium to its Net Asset Value (NAV). This price discrepancy is caused by supply and demand factors and may be particularly likely to emerge during periods of high market volatility and uncertainty. This phenomenon may also be observed for ETFs tracking specific markets or sectors that are subject to direct investment restrictions.|
|Liquidity risk||Securities Market Makers (SMMs) are Exchange Participants that provide liquidity to facilitate trading in ETFs. Although most ETFs are supported by one or more SMMs, there is no assurance that active trading will be maintained. In the event that the SMMs default or cease to fulfill their role, investors may not be able to buy or sell the product.|
3. ETF Advantages
|Transparency||Each ETF has its own website operated by its ETF manager (a list of ETFs' websites can be found on the HKEX website). ETFs' websites provide key information such as the underlying benchmarks and the benchmarks' constituents, the ETF's Net Asset Value (NAV), the counterparty exposure and details of collateral from counterparties. The NAV of an ETF is the sum of marked-to-market values of the individual portfolio holdings plus the portion of the assets held in cash and cash equivalents, less all the accrued ETF expenses. The NAVs of ETFs are calculated intra-day during the trading hours and at the end of the trading day. The intra-day estimated NAVs, or iNAVs, are also known as RUPVs (Reference Underlying Portfolio Value) or IOPVs (Indicative Optimized Portfolio Value). The end-of-day NAV information may also be obtained on the HKEXnews website, in addition to the ETF's website. Real-time or delayed price quotes for ETFs are disseminated by information vendors and are available on the HKEX website.|
|Low transaction costs||Unlike unlisted funds, ETFs do not charge any subscription fees. The transaction costs for trading ETFs at HKEX are the same as those for trading other securities, which include brokerage commission, transaction levy, investor compensation levy (currently suspended), trading fee, trading tariff and stamp duty (Some ETFs are exempted from stamp duty).|
|Low minimum investment||ETFs are traded in board lots and the minimum initial investment is usually set at an affordable level.|
|Liquidity||ETFs can be traded any time during the trading hours of the securities market. Listed ETFs usually have market makers, which are known as Securities Market Makers, to provide some liquidity. However, market making for the ETFs is available only during the Continuous Trading Session. The list of market makers for each ETF as well as their contact details are published on the HKEX website|
|Convenience||ETFs are traded through brokers in the same way as other securities and the settlement arrangements are the same.|
|Diversification||Most ETFs track a portfolio of assets to provide diversified exposure to selected market themes. However, ETFs may also track a single underlying asset such as gold.|
|Market exposure||While some ETFs provide Hong Kong investors access to a basket of Hong Kong securities, others provide the investors access to overseas markets or other asset classes.|
References:Hong Kong Exchanges and Clearing Ltd.
Investor Education Centre