Leveraged and inverse exchange-traded funds have been a huge success among retail investors in Japan and Korea, but their introduction in Hong Kong is being held up by an over-cautious regulator, argue industry executives.

The first batch of L&I products is not expected until the fourth quarter of this year, and funds with China or Hong Kong underlyings are unlikely until mid-next year at the earliest. There are concerns that if the first wave of such ETFs does not take off, interest will be low in those to follow.

The Securities and Futures Commission (SFC) has been under pressure from asset managers to encourage new products that will boost investor participation in the ETF market.The government-backed Financial Services Development Council has also weighed into the debate, suggesting that Hong Kong is being overtaken by other markets in Asia as an ETF hub.

L&I products would provide the market with just such a boost, giving investors a greater choice of market exposure, say fund managers. Indeed, they may well form the core market for ETFs in Hong Kong, if experience elsewhere in Asia is a guide.

The products use derivatives to boost the returns of an index over a short period, typically one day, and are not designed for use over an extended period. Inverse ETFs do the same for investors who want to short an index. Two times leverage is typically applied on the long side.

While they are designed to boost returns for day traders, they carry the risk of exaggerated losses if the index falls. Hence they are viewed as speculative, and as a result the SFC is taking a cautious view. 

The regulator had previously stated its concern to AsianInvestor and remains tentative about exposing retail investors to these funds. One reason for this caution is that in Asia – currently Japan and Korea – the L&I market is dominated by retail investors, unlike in Europe and the US, where institutions are the main players.

This nervousness is understandable, given the history of big retail investor losses from products in Hong Kong, notably Lehman minibonds in the wake of the 2008 financial crisis. But industry executives argue it is overdone.

The products will be introduced in two phases in Hong Kong to allow investors time to familiarise themselves with them and to allow the SFC to monitor their potential impact.

In the first phase, the regulator is only willing to look at indices excluding Hong Kong and China, so initial products are likely to reference major benchmarks such as MSCI World, S&P 500, Nasdaq 100, FTSE 100 or Nikkei 225.

Hence a wider market of ETF variant products, including local indices, is still some way off. Phase two will not start until the SFC has conducted a review six months after the launch of the initial batch, to consider including Hong Kong equity indices. That means mid-2017 at the earliest, on the assumption that the first-phase products appear in the fourth quarter of this year, as some industry observers expect.

Contrary to the widely held view that phase two will include mainland indices, the SFC has said it has no plans to accept applications for L&I funds tracking mainland indices. This may be due to mainland concerns about the effect these products might have on the stock market, at a time when Beijing is anxious to stabilise trading activity.

The market needs inverse ETFs in particular because there are few other options if investors want to hedge their stock exposure, argue product promoters. 

Hong Kong already has its own leveraged products in the form of listed derivative warrant, a market that is highly retail and freely tradable for a minimum investment of HK$2,000 ($258) for up to five times leverage.

By contrast, leveraged ETFs are typically only offering two times leverage, so industry observers question why they need to be so heavily controlled. But this stance is consistent with the SFC’s previous attempts to prevent alternative products from hitting the mainstream.

ETF issuers declined to confirm their intention to be involved in the first phase.

Like other potential L&I product providers, Tobias Bland, chief executive of Hong Kong asset manager EIP, is watching to see what happens in phase one: “If anyone nails it with a product in the first phase, that will be great, but the real appetite is in the Hong Kong and China indices.”

A longer version of this article appears in the March edition of AsianInvestor Magazine, available now.