Synthetic ETFs

Last week SFC and HKEx a new effort to raise investors' awareness of Exchange Traded Funds (ETFs) that primarily adopt synthetic replication strategy (synthetic ETFs). A traditional ETF (also known as physical ETF) invests in securities that replicate or represent the composition of the index it tracks, and a synthetic ETF uses financial derivative instruments to track index performance.


A manager of an ETF may adopt one or more of the following strategies to achieve the fund's index tracking objective:

1. full replication by investing in a portfolio of securities that replicates the composition of the underlying index;
2. representative sampling by investing in a portfolio of securities featuring a high correlation with the underlying index, but not exactly the same as those in the index; or
3. synthetic replication through the use of financial derivative instruments (such as swaps and performance-linked structured products issued by counterparties) to replicate the index performance. 

Synthetic ETFs' managers have agreed to adopt new measures aimed at helping investors to better differentiate between index tracking strategies of ETFs. The new measures, supported by the SFC, HKEx and the industry following extensive discussions, are in line with ongoing efforts to strengthen protection for investors.


Addition of marker to stock short names of synthetic ETFs


Effective from 22 November, 2010, a marker X will be placed at the beginning of the English and Chinese stock short names of all synthetic ETFs listed on SEHK.


The marker will make synthetic ETFs more visible on the stock pages of HKEx's securities trading system and on the HKEx website and the HKExnews website. The stock short names of traditional ETFs will remain the same.


Annotation of names of synthetic ETFs


Building on the preceding measure, by 16 January 2011, managers of synthetic ETFs will be required to put an asterisk (*) and an annotation in English "(*This is a synthetic ETF)" and in Chinese "(*此基金為一隻合成交易所買賣基金)", as the case may be, right after the name of a synthetic ETF whenever it appears in offering documents and marketing materials for a synthetic ETF issued by the manager or on the manager’s behalf to investors in Hong Kong.


This requirement will also be applicable to all notices and other communications with Hong Kong investors in respect of synthetic ETFs whenever the name of the synthetic ETF is mentioned, including information on the corporate websites for Hong Kong investors run by or on behalf of synthetic ETFs' managers.


Investor education initiatives


SFC will continue its investor education efforts to help investors better understand synthetic ETFs.


HKEx is updating its product education material to explain the purpose of the stock short name marker and the risks of ETFs using synthetic replication.


HKEx will also enhance the HKEx website to highlight disclosure of ETF product features. For example, it will indicate which ones use synthetic replication and which ones do not. This will help investors find ETFs by their product features more easily.


HKEx has enhanced the hyperlinks to ETF websites from the HKEx website to provide easier navigation to ETF websites.


Other measure to enhance transparency of ETFs


To assist managers of ETFs in complying with the ongoing disclosure obligations under the Code on Unit Trusts and Mutual Funds and/or Listing Agreement, SFC and HKEx today jointly issued a circular containing a list of potential events that may trigger such disclosure obligation.


Jack's comment: Retail investors should thank Next Magazine's article published several months ago for reporting the danger of synthetic ETFs. SFC is often working on hindsight when handling products.