Members of the exchange-traded fund (ETF) industry are holding their breath, wary of a regulatory response to a recent cover story in Hong Kong magazine Next.  

The Chinese-language tabloid, more commonly associated with celebrity exposés, reported in late July that the popular iShares FTSE/Xinhua A50 China index ETF was a derivative product that doesn’t hold the underlying A-share securities it is built to track. 

The article noted that the A50 had low collateral and suggested such products could face a minibonds-style meltdown owing to the level of counterparty risk.  

Although investors may assume the ETF holds the underlying shares that make up the A50, which would offer additional security, the reality is that it buys swaps from investment banks to gain index exposure. 

Owners of the ETF would therefore be at risk if the investment banks ran into financial trouble, as happened to holders of Lehman Brothers products when that firm collapsed. 

Creators of China-focused ETFs typically enter into a swap arrangement with an investment bank that holds a licence as a Qualified Foreign Institutional Investor (QFII) in the country.  

That’s because QFII quotas have been given out sparingly, mostly to the largest investment banks, and don’t meet the demand for investors looking to tap Chinese markets. 

Industry sources note it is very difficult to create ETFs focused on markets such as China and India without using derivatives since access to those markets is restricted. 

China-focused ETFs do not use leverage, which is one aspect of derivative products that makes them risky. Some products have suffered spectacular losses when the derivatives moved in unexpected ways. 

Yet market participants are generally of the view that the Next article, which unleashed a flood of investor criticism, sensationalised the issue and are waiting to see if the Securities & Futures Commission (SFC) will respond with new rules. 

“The SFC is having a lot of response [to the article],” says one asset manager who wanted to remain anonymous. “It has gotten to be so political. Decisions are made based on this perceived public back-lash rather than reality.” 

Sources have speculated that, on the back of the article, the SFC could seek to restrict the creation of swap-based and other synthetic ETFs, which do not hold underlying securities – as the bulk of ETFs do in the US.  

Such a move would severely handicap issuers of synthetic ETFs in Hong Kong. While there are 16 ETFs in the city based on replication of an index – owning some or all of the underlying stocks – there are a further 49 that use synthetic replication. Deutsche, Lyxor and iShares all have multiple synthetic ETFs listed in Hong Kong.  

BlackRock, which now owns the iShares business, issued a statement shortly after the Next story was published. “Transparency resides at the heart of the global iShares value proposition,” the company stated, while clarifying that the iShares A-Share ETFs do not invest directly in China A-shares.  

It added that information was featured on its website including its eight China-focused ETFs. Plus BlackRock noted that it uses 12 different counterparties to provide swaps for the iShares A50 product to reduce risk.  

But the asset manager interviewed above does not anticipate drastic SFC action. “I think most of the discussion coming out is about further disclosure,” he says. “How do you alert people to the mechanism?” 

The SFC did not respond directly to the Next article, and says Next did not contact it for its story. But a spokesman notes that the watchdog has published material to educate investors about ETFs and index shares.  

The SFC’s InvestEd website advises investors about the differences between synthetic ETFs and those that use replication or sampling, and features details on the dangers of ETFs, including counterparty risk and tracking error. 

The SFC declined to comment on whether it would restrict approval of synthetic ETFs in the future. It has not approved any synthetic ETFs since the publication of the Next article. 

Investor protection became a key focus for the SFC following the September 2008 demise of Lehman Brothers, which left 43,700 investors in Hong Kong and Singapore with exposure of around HK$15.7 billion ($2 billion) to Lehman minibonds. 

The SFC says it has reached deals with all 19 companies that distributed the minibonds in Hong Kong to repay HK$5.2 billion to some 24,400 bank customers who bought the products. 

But whereas the minibonds were distributed via banks, ETFs are simply listed on the exchange and can be bought and sold through online or regular brokerage accounts.  

Both the SFC and the ETF industry share an interest in improving investor education, although quite how to achieve that remains open to debate. “Unlike Lehman, there’s no distributors, so they can’t climb on the distributor,” the asset manager reflects.