Are synthetic ETFs set for a rebirth in Hong Kong?

The SFC has just authorised two sets of synthetic ETFs after a gap of a year-and-a-half, suggesting it is ready to approve such products again after a bout of regulatory tightening.
Are synthetic ETFs set for a rebirth in Hong Kong?

Hong Kong’s securities regulator appears to have reopened the market for synthetic exchange-traded funds after a hiatus of a year-and-a-half, fuelling expectations that 2012 will see more such products listed in the city.

Just yesterday db x-trackers – Deutsche Bank’s ETF unit – launched six synthetic funds on the Hong Kong Stock Exchange, bringing the total of synthetic ETFs on the HKSE to 55. That’s double the number of physically-backed products it has (28).

The latest batch of Deutsche funds tap equity markets in Indonesia, Thailand and Malaysia, and also includes the first ETF in Hong Kong linked to overnight Australian dollar interest rates.

These funds were approved by the Securities and Futures Commission on December 30 last year, meaning the German bank has taken less than two weeks from authorisation to listing.

Earlier this week, Enhanced Investment Products (EIP) revealed it too was set to list a suite of synthetic emerging market ETFs on February 16 after receiving SFC authorisation on January 9 – a processing period of over five weeks.

EIP’s seven funds will focus on India (S&P CNX Nifty), Indonesia (LQ45), Korea (Kospi 200), Malaysia (Bursa Malaysia KLCI), Philippines (PSEi), Taiwan (Taiex) and Thailand (SET50).

Although the SFC has said it never stopped processing ETF applications, the last synthetic products it authorised prior to db x-trackers’ batch were on July 15, 2010: the iShares CSI A-share consumer discretionary index ETF and the iShares CSI A-share energy index ETF.

In that intervening 18-month period it has approved a total of 12 physically-backed ETFs. And while investor appetite and sentiment have evidently been tested (the Hang Seng Index plunged 10% over the period, and 21% for calendar 2011), it’s also true that synthetic replication hit the headlines in Hong Kong last year over the potential for counterparty risk.

Last August the SFC announced additional measures to enhance the level of collateral and transparency of domestic synthetic ETFs in a drive to strengthen investor protection.

Relevant managers were required to top up collateral for each domestic synthetic product to achieve at least 100% collateralisation to ensure there was no uncollateralised counterparty risk exposure. They had already been required to add an asterisk to all synthetic ETFs to indicate their status to investors.

AsianInvestor understands the SFC took around 18 months to approve EIP’s new suite of swaps-based ETFs; Paul So, EIP’s head of beta products, admitted it had been a long process.

Although db x-trackers’ synthetic ETFs are not Hong Kong domiciled and therefore not subject to the same strictures, Marco Montanari, head of Deutsche Bank’s ETFs and db-X funds for Asia, confirms there was plenty of to and fro on product structure during the approval process.

Deutsche has a total of 47 synthetic ETFs listed in Singapore and now 30 synthetics in Hong Kong, and Montanari expresses a desire for the latter to catch up. “We think having ETFs in Hong Kong is an advantage as institutional and foreign investors look to invest in Hong Kong as a key hub,” he notes, naming Japanese e-brokers and Chinese QDII investors among them.

He points out that the SFC has never said it preferred one type of ETF to another and notes that Deutsche will try to list more funds in the city, adding his expectation that Hong Kong will see more synthetic products listed this year.

ETF turnover in the city decreased by around 10% last year to $70.1 billion, which Montanari blames on the performance of the A-share market and Hong Kong exchange.

But he expresses confidence that Hong Kong will see positive ETF inflow in 2012 on the back of more non-HK, non-China products to tap overseas growth prospects, product innovation and greater investor education.

EIP’s So is also aiming to list more ETFs in the city. “We have a product pipeline and plan to launch more ETFs in Hong Kong for investors around our speciality of emerging markets,” he states.

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