Fears that leveraged and inverse (L&I) exchange-traded funds put Hong Kong investors’ capital at undue risk are unfounded, said Stewart Aldcroft, senior adviser in Citi’s investor services division.

The city’s Securities and Futures Commission (SFC) now appears comfortable with the products, having approved a raft of ETFs linked to Hong Kong stocks and H-shares, which listed on March 14. It had initially prohibited listings based on China and Hong Kong underlyings when it allowed the first L&I products in June last year.

Yet doubts remain as to their suitability for retail investors. Jessica Cutrera, managing director at Hong Kong-based wealth manager Capital Company, said her biggest concern was that L&I products would be misunderstood. “They mostly have a daily reset,” she noted. “They are not made for asset allocation and are not appropriate for taking a long-term view.”

However, Aldcroft argued that while some investors may misunderstand and misuse L&I funds, the wider risk was overstated. He believes L&I funds are “the right product for the types of investor we see in our market”.

Hong Kongers: traders at heart

After all, Hong Kong investors are traders, said Aldcroft. “When you see them in the securities houses, these retail traders, there are thousands of them sitting in front of screens, and these are moms and pops.

“They are not professionals by any means and all they are doing is punting stocks and, even more so, warrants, which are highly leveraged versions of stocks," he added. "So to even suggest that these people are inexperienced on risk should be seen as an insult to their knowledge.”

L&I 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. Typically two times leverage is applied on the long side and one on the downside.

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, leading to the SFC’s cautious approach to approving them.

The difference in investor behaviour shows the potential for retail investors to be at a disadvantage. He pointed out that professional investors close out their positions every night and open new ones the following day, while retail investors may stay in overnight.

Sufficient clarity?

Cutrera said investors could lose a lot of money on short-term volatility if they held onto their L&I funds. She believes marketing materials don’t always make it clear how these products work. 

Aldcroft conceded that some people may not fully understand how the products operate and could lose a lot of money, because they are designed for daily dealing.

Peter Lee, head of global strategy for ETFs at Samsung Asset Management, confirmed: “The biggest risk, if you hold the fund for more than one business day is that the actual return may differ from some people’s common-sense assumption.”

But he said his company’s sales literature makes it clear the objective of the fund is to achieve a two-times return on a daily basis. “So the next day is a reset, and therefore it’s not two-times from the opening price, necessarily.”

The market is still heavily institutional, but the proportion of retail investors will increase, if the South Korean and Taiwanese markets are any guide, said Lee, as retail investors gain more comfort with these products.

Aldcroft does not believe L&I funds would exacerbate market volatility in Hong Kong due to the by increase the level of 'herding' into certain stocks and markets, nor that they would cause problems for market-makers seeking to create and dissolve a large quantity of units in a short time.

“Hong Kong is too big a market for that,” he noted. “It’s a deep market with a lot of stocks across different sectors and has considerable institutional investor interest.”

The latest L&I products listed in Hong Kong were introduced by China Asset Management, CSOP Asset Management, Mirae Asset Global Investments and Samsung Asset Management. Each manager has listed four products, two leveraged and two inverse, for Hang Seng Index (HSI) and H-share exposure. Earlier this week, Guangzhou-based E Fund, listed a China-related leveraged fund in Hong Kong.

L&I funds accounted for $71.4 billion in assets worldwide as of end-February, a small fraction of the global $3.844 trillion ETF market, according to research firm ETFGI. But it is growing at a decent clip, bringing in $8.35 billion of net new assets last year. Average daily volume is perhaps more relevant measure for these products than for most other ETFs; it stood at $8.1 billion globally as of February 2017.