(A) BASIC ETF KNOWLEDGE
What is an ETF?
An ETF is an open-ended fund that can be traded like a share on the security exchange. An index-tracking ETF is a listed collective investment scheme that aims to track the performance of the underlying index. The underlying index can be on a security market, a segment of the security market, or even bonds and securities.
What is the aim of investing in ETFs?
By investing in ETFs, investors may receive a return that replicates (usually not 100%) the performance of the index without physical ownership of the index constituent securities.
How does an ETF track the performance of its underlying index?
Tracking is usually achieved by using full replication or representative sampling, or synthetic replication strategies.
Using a full replication strategy means that an ETF will invest in the constituent securities of the underlying index in substantially the same weightings as these securities have in the index. Hence, the performance of the ETF will match the performance of the underlying index as closely as practicable.
An ETF adopting a representative sampling strategy holds a sample of securities that have similar features such as market capitalisation, industry weights and liquidity to the constituent securities of the underlying index. ETFs that use this strategy tend to have a higher risk of tracking error than those using a replication strategy.
A synthetic replication strategy means that the ETF will invest in financial derivative instruments to replicate the index performance. There are additional risks associated with such strategy that are not found in the above two strategies.
Management of ETFs
Most ETFs are passively managed by managers who will invest in the constituent securities of the underlying index according to its respective weightings in the underlying index.
When a constituent security itself or its weighting in the underlying index changes, managers are responsible for implementing the necessary adjustments to the ETF's portfolio of securities to ensure that the composition and weightings of the securities held by the ETF closely corresponds to that of the underlying index.
Market price of ETFs
The market price of each ETF unit is largely based on its net asset value ("NAV") per unit. However, as ETF units are traded on the security exchange, there may be a disparity between the market price and the ETF’S NAV due to market forces, such as supply and demand. With the presence of the creation and redemption mechanism, such divergence should be minimal under normal circumstances.
Comparison between ETFs vs. shares vs. funds
||Traditional open-ended investment funds
||Fund Manager or Distributor
||Intraday during exchange trading hours
||Intraday during exchange trading hours
||Subscription and redemption applications before the cut-off time on the fund's dealing day
|Minimum Trading Size
How to invest in ETFs?
In Secondary Market:
An investor can invest in an ETF by simply opening an account with an authorised stock broker and start investing in an ETF in a process similar to purchasing and selling securities.
In Primary Market:
If an investor intends to invest a substantial amount in an ETF, he or she may contact one of the ETF's Participating Dealers (“PD”). The PD can assist the investor in creating ETF units with the ETF's manager, with applicable transaction fees and brokerage commission agreed upon between the investor and the PD.
What are the general investment risks?
The risks of investing in ETFs include but are not limited to the following points:
- To the extent that the underlying index concentrates in the securities of a particular industry or group of industries, the performance of ETFs could be more volatile than the performance of less concentrated funds?
- Like other index-tracking funds, an ETF is not actively managed meaning the manager does not have the discretion to select securities individually or to take defensive positions in declining markets. Hence, any fall in the underlying index will result in a corresponding fall in the value of the ETF. On the other hand, no assurance can be given that the performance of an ETF will be identical to the performance of the underlying index due to many factors?
- Although ETF units will be listed on a security exchange, there can be no assurance that active trading in the ETF units can be maintained.
In general, an investor should consider if an investment in ETFs is a suitable investment for himself or herself in terms of his or her financial situation, investment experience and investment objectives. The investor should read the offering documents of the relevant ETF (including the full text of the risk factors stated therein) in detail before making any investment decision. It should be noted that investment involves risks (including the possibility of loss of the capital invested), that prices of ETF units may go up as well as down and past performance information is not indicative of future performance.
(B) FOCUSING ON THE CONCEPT OF RQFII ETF
What is RQFII?
RQFII is a new policy initiative of the Mainland authorities which allows qualified RQFII holders to channel RMB funds raised in Hong Kong to be invested into the PRC securities markets. RQFII holders may issue public or private fund or other investment products using their RQFII quotas. RQFII funds give retail investors access to invest in PRC securities markets as they can invest RMB directly into the PRC bond and equity markets (including the inter-bank bond and exchange-traded bond market) through the RQFII quotas. Subscriptions and redemptions of units in the fund must be settled and paid in RMB. Like other funds, RQFII funds must be authorized by the SFC before they can be marketed to the public in Hong Kong. RQFII is granted to Hong Kong subsidiaries of qualified Mainland asset management and securities firms which allows them to channel RMB raised in Hong Kong to invest in the Mainland securities markets.
What is RQFII A-share ETF?
RQFII A-share ETF is a RMB-denominated physical A-share ETF. Through the RQFII investment quota granted by Mainland authorities, an RQFII A-share ETF seeks to track the performance of an A-share index by channeling the RMB raised outside mainland China to invest directly in a portfolio of A-shares. RQFII A-share ETFs are traded on the Stock Exchange of Hong Kong (SEHK) like stocks. Like other ETFs listed on the SEHK, RQFII A-share ETFs must be authorized by the SFC before they can be offered to the investing public. Investors are reminded that they should read the EFT’s offering document) carefully to understand its key features and risks before making an investment.
Why invest in RQFII ETF?
An RQFII ETF will invest RMB solely and directly into the PRC securities markets through its RQFII quota. This means that investors are fully exposed to the RMB currency and PRC domestic securities markets. It should be noted that not all issuers of RMB funds issued in Hong Kong have the pre-approved RQFII investment quota to invest RMB directly in securities and bonds issued in the PRC. In such cases, the issuer may be able to invest in only either offshore RMB denominated investments (e.g. dim sum bonds) or in non-RMB assets.
What are the key differences between RQFII A-share ETFs and other existing RQFII retail funds currently available to Hong Kong investing public?
||RQFII A-share ETFs
||RQFII retail funds
|RQFII quota requirement
|Listing on SEHK
||A-shares traded in the Mainland markets
||At least 80% in RMB bonds and bond funds issued in mainland China, not more than 20% in China A-shares and other equity investments
Description of the Underlying Index
The FTSE China A50 Index is a free float-adjusted market capitalisation-weighted index compiled and published by FTSE International Limited (“FTSE”) and is a real-time, tradable index comprising of the largest 50 A-Share companies by full market capitalisation. The index offers the optimal balance between representativeness and tradability for China’s A-Share market. It is a price return index and includes securities listed on both the Shanghai and Shenzhen security exchanges.
Salient terms of the CSOP A50 ETF
Investors will be informed that the minimum trading size of the CSOP A50 ETF is 200 units, that the ETF operating cost includes Management Fee, Trustee Fee and other expenses of which full details can be found in the ETF’s prospectus.
Investors will also be informed that prior to making an investment in the ETF, they will be required to consult with their stock broker or financial adviser for account set-up details to trade RMB products.
Who should invest in an RQFII ETF?
Investors who want to retain their RMB (CNH) holding and who are positive about the China A-Share market should invest in the ETF. However, investors should consider the product specific risks outlined below. Investors should also read the offering document and the product key facts statement (Product KFS) of the Fund carefully to understand the key features and risks of the RQFII fund and contact their intermediaries before making any investment.
What are the key differences in structure and trading between RQFII A-share ETFs and other A-share ETFs currently traded on the SEHK?
||RQFII A-share ETFs
||Other A-share ETFs
|Investment strategy and replication/ tracking method
- Physical full replication or representative sampling
- Direct investment in the Mainland securities markets through RQFII investment quota
- Invest directly in A-shares that replicate or represent the composition of the underlying A-share index
- Synthetic replication
- No direct investment in or holding of Mainland securities
- Invest in derivative instruments to replicate the underlying index performance
||RMB and HK dollar
Is there any specific condition on RQFII A-share ETFs that may lead to the suspension of new unit creation?
RQFII A-share ETFs may suspend the creation of new units when, among others:
- the RQFII investment quota is used up, and
- the RQFII holder cannot obtain additional quota in a timely manner.
In such event, the units of RQFII A-share ETFs may trade at a significant premium to their NAV.
What are the risks involved in RQFII funds in general?
The risks of investing in RQFII funds include but not limited to the following points:
RQFII regime risk
The RQFII policy and rules have only been recently announced and there may be uncertainty as to its implementation and such policy and rules are subject to change and interpretation by PRC authorities. The uncertainty and change of the laws and regulations in the PRC (including the RQFII policy and rules) may adversely impact the RQFII fund.
Risks relating to Mainland markets
The concentration of RQFII fund's investment in securities and bonds issued in mainland China may result in greater volatility than portfolios which comprise of broad-based global investments.
Investing in PRC-related companies and in the PRC markets involve certain risks and special considerations not typically associated with investment in more developed economies or markets, such as greater political, tax, economic, foreign exchange, liquidity and regulatory risks.
There are risks and uncertainties associated with the current Chinese tax laws applicable to investments made by an RQFII fund. Although some RQFII funds may have made tax provision in respect of potential tax liability that may arise from their investments, the provision may not be sufficient or may even be excessive. Any shortfall between the reserves and actual tax liabilities may have to be covered by the fund's assets and may adversely affect the fund's asset value.
Since an RQFII fund is denominated in RMB, Hong Kong dollar-based investors are therefore exposed to fluctuations in the RMB exchange rate against the Hong Kong dollar. Like any currency, the exchange rate of the RMB may rise or fall. The RMB is currently not freely convertible and is subject to exchange controls and restrictions.
An RQFII fund is an investment fund product and not a bank deposit. In general, there is no guarantee of the repayment of principal or dividend payment.
The underlying investments of an RQFII fund may fall in value and therefore investment in the fund may suffer loss even if RMB appreciates.
Reliance on market maker risk
Market makers may not be as interested in making a market in ETF units denominated in RMB. Any disruption to the availability of RMB may adversely affect the capability of market makers in providing liquidity for the units of RQFII A-share ETFs. The liquidity of the ETF may be adversely affected if there is no market maker for the fund or if the market making activities are not effective.
Other specific risks from investing in the PRC:
China market risk
By investing in the China market, investors will be exposed to both emerging markets risks and risks specific to the China marker.
Any significant change in PRC’s political, social or economic policies may have a negative impact on investments in the China market and this will affect the value of the Fund. The regulatory and legal framework for capital markets and joint security companies in the PRC may not be as well developed as those of developed countries. Chinese accounting standards and practices may also deviate significantly from international accounting standards. The settlement and clearing system of the Chinese securities markets may not be well tested and as such, may be subject to increased risks of error or inefficiency.
As the number of PRC securities and their combined total market value are relatively small compared to more developed markets, investments in these securities may be subject to increased price volatility and lower liquidity. The PRC securities market has in the past experienced substantial price volatility, and there is no assurance that such volatility will not occur in future.
Investors should also be aware that changes in the PRC taxation legislation could affect the amount of income which may be derived and the amount of capital returned from an investment into a RQFII ETF.
Foreign exchange control risk
The PRC government may also impose restrictions on the repatriation of RMB out of China. This will in turn limit the depth of the RMB market in Hong Kong, thus reducing the liquidity of the Fund. The Chinese government’s policies on exchange control and repatriation restrictions are also subject to changes which may affect the fund’s positions.
Government intervention and restrictions risk
The operation and market making activities of RQFII A-share ETFs may be affected by interventions by the governments and regulators in the financial markets, such as an imposition of trading restrictions, a ban on "naked" short selling or the suspension of short selling for certain stocks.
(C ) CROSS-BORDER KNOWLEDGE
How is the CSOP A50 ETF a cross-border ETF?
The CSOP A50 ETF aims to track the performance of the underlying index by directly investing in the constituent securities of the underlying index which are solely A-Shares. However, the ETF itself is listed on the Hong Kong Exchanges and Clearing Limited. A cross-border flow of money will thus occur in the investment process.
Brief description of the A-share market:
The PRC has two security exchanges - the Shanghai Security Exchange (“SSE”) which was established in November 26, 1990 and the Shenzhen Security Exchange (“SZSE”) which was established in December 1, 1990. The two exchanges are under the direct management of the CSRC. The main functions include providing premises and facilities for securities trading, developing the business rules of the exchanges, organising and supervising securities trading and regulating exchange members and listed companies amongst others.
Since establishment, both the SSE and SZSE have made great achievements in terms of the quantity and types of products listed on them. Currently listed products include A-Shares, B-Shares, funds and bonds. As of May 31, 2012, the number of listed companies amounted to 2412, of which 933 were listed in Shanghai and 1479 were listed in Shenzhen. The combined market capitalization of both the SSE and SZSE amounts to 23.9 trillion Yuan.
Differences between the A-Share and H-Share markets
The A-share market opens at 09:30 and closes at 11:30 for the morning trading session. The afternoon trading session opens at 13:00 and closes at 15:00.
The Hong Kong Security Exchange opens at 09:30 and closes at 12:00 for the morning trading session. The afternoon session opens at 13:00 and closes at 16:00.
The A-share and Hong Kong markets also have a different holiday schedule.
“T+ 0” vs. “T+1” Trading Rule:
The A-share market has the T+1 trading rule which means a security bought on T day can only be sold on T+1. Short-selling is prohibited with an exception made for instruments covered by a pilot program. No such rule exists in the Hong Kong market, save that short-selling is only permitted in securities which meet certain requirements.
The A-share market settles on a T+1 basis, while the Hong Kong market settles on a T+2 basis.
CNH vs. CNY
Following the introduction of a series of policies by the PRC authorities, a RMB market outside the PRC has developed and has expanded rapidly since 2009. RMB traded outside the PRC is often referred as “offshore RMB” or “CNH”. In contrast, RMB that is traded in the PRC is often referred to as “onshore RMB” or “CNY”.
Both onshore and offshore RMB are the same currency but are traded in different markets. Since the two RMB markets operate independently, with much restriction placed on the flow between them, both onshore and offshore RMB are traded at different rates. Due to the strong demand for CNH, CNH was previously traded at a premium compared to CNY, although occasional discounts are observed. The relative strength of both the onshore and offshore RMB may change significantly within a short period of time.
Cross Border Investment Risks
Offshore RMB/CNH market risk
Although it is expected that the offshore RMB market will continue to grow in depth and size, its growth is subject to many constraints as a result of PRC laws and regulations on foreign exchange. There is no assurance that new PRC regulations or arrangements will not be promulgated, terminated or amended in the future which will have the effect of restricting the availability of offshore RMB. The limited availability of RMB outside the PRC may affect the liquidity of the CSOP A50 ETF.
Offshore RMB/CNH Remittance Risk
The RMB is currently not freely convertible and is subject to exchange control imposed by the PRC government. There is no assurance that new PRC regulations will not be promulgated in the future which have the effect of restricting or eliminating the remittance of RMB into or outside the PRC. Such an event could have a severe adverse effect on the operations of the CSOP A50 ETF.
Risks relating to RMB trading and settlement of units
It is likely that not all intermediaries are prepared to carry out trading and settlement of RMB-denominated securities. In addition, the liquidity and trading price of the units of RQFII A-share ETFs may be adversely affected by the limited availability of RMB outside mainland China and the restrictions on the conversion between foreign currency and RMB.
Although the SEHK has launched the RMB Equity Trading Support Facility (TSF) to enable investors who have insufficient RMB to buy RMB-traded shares, the TSF only supports secondary trading of RMB shares currently and not other types of securities. Therefore, investors cannot use this facility to buy RQFII A-share ETFs.
Trading differences risk
While A-shares are subject to trading bands which restrict increases and decreases in the trading price, trading of RQFII A-share ETFs listed on the SEHK is not subject to such restrictions. This difference may affect the level of premium or discount of the trading price of the ETF's units to its NAV.
Mainland brokerage risk
Only one brokerage can be appointed for each market (the Shenzhen Stock Exchange and the Shanghai Stock Exchange) to execute transactions (i.e. trading of A-shares) for the RQFII A-share ETF in mainland China. As such the RQFII A-share ETF will rely on only one brokerage for each market, which may be the same brokerage. If the manager of the RQFII A-share ETF is unable to use its designated brokerage in mainland China, the operation of the RQFII A-share ETF will be adversely affected and may cause the units of the RQFII A-share ETF to trade at a premium or discount to the RQFII A-share ETF's NAV or the RQFII A-share ETF may not be able to track the underlying index.
Reliance on parent company risk
The manager of RQFII A-share ETFs may not be experienced in managing ETFs and may heavily leverage on the expertise and systems of its Mainland parent company to support the RQFII A-share ETF's investments in the A-share markets. Any disruption in the assistance from the Mainland parent company may adversely affect the operations of the RQFII A-share ETF.
Risks in light of the cross-border nature of the CSOP A50 ETF
The CSOP A50 ETF is subject to operational and settlement risks due to its cross-border nature. Operational risks may also be present in the form of communication and trading systems failure. As the CSOP A50 ETF transacts in the China A-Share market, the CSOP A50 ETF may also be exposed to cross-border settlement risks. This may affect the ability to ascertain the value of the CSOP A50 ETF’s portfolio and this may adversely affect the CSOP A50 ETF.