Acceptable risks

Exchange-traded funds (ETFs) are relatively new to Hong Kong's investment scene, but their popularity is growing among professional and individual investors. The prominence of ETF advertisements on trams, buses and the MTR suggests that both institutional and retail investors are becoming important customers for providers. Although they can be complex, ETFs offer asset managers and investors an attractive way to manage their portfolios on proven platforms for diversifying risk, especially in today's volatile markets.

Hong Kong also offers domestic synthetic ETFs; investments that mimic the behaviour of ETFs through the use of derivatives such as swaps. In August, the Securities and Futures Commission introduced rules to lift collateral levels and improve the transparency of these synthetic ETFs to strengthen protection for investors. ETF managers who administer locally originated synthetic ETFs will have to increase collateralisation to ensure there is no uncollateralised counterparty risk exposure.

Synthetic ETF managers will also be required to further increase collateral to 120 per cent of the related gross counterparty risk exposure in the event that the collateral is represented by equity securities. While the commission is meeting international standards, is there more they can do for the investing public? Will this translate into real benefits? And can more be done to show how ETFs work?

ETFs provide a low-cost and transparent way into a wide variety of asset classes and hedge strategies. They have emerged as credible and competitive alternatives to both active and passive funds. However, increasingly complex ETFs such as leveraged and inverse ETFs are difficult to understand and can introduce new and misunderstood risks to portfolios.

Although ETFs are offered under a bewildering array of names and purposes, the individual investor can better understand them by thinking of them as combining the key features of traditional mutual funds and individual stocks. Much like a fund, they provide exposure to a diversified basket of securities to track a specific equity, situation, fixed income or commodity benchmark. These benchmarks may be conventional like the S&P 500 or China A shares. They can also be specially constructed to track specific sectors like technology.

Conventional ETFs track indexes through direct holdings of securities such as stocks or commodities. The newer breeds of synthetic ETFs hold derivatives that are supposed to reflect the returns of underlying securities. Both synthetic and conventional ETFs give the investor the same effect as building their own portfolio. However, ETFs provide greater and easier trading flexibility because they can be bought and sold on an exchange.