This article was originally published in Financial Services Quarterly Report.
Asian ETF Markets are Ripe for Growth
Asian exchange-traded fund ("ETF") markets are poised for imminent rapid growth. While ETF markets are still in their nascent stages of development in many parts of Asia, and lag behind those of the United States and Europe in terms of maturity and size, ETFs have become increasingly popular with both institutional and retail investors, and their vast potential can be appreciated from a number of perspectives.
Driven partly by core drivers of growth, including convenience, cost effectiveness, liquidity, flexibility and transparency, Asian ETF markets have demonstrated a robust momentum on the back of the global financial crisis and general volatile market conditions. In terms of assets under management ("AUM"), Japan's ETF market is the largest in Asia at USD27.3 billion. The total amount of AUM in ETF markets in the Asia ex-Japan market increased from USD27 billion in 2007 to USD40.6 billion by the end of the first quarter of 2010.1 Outside Japan, Hong Kong has become the largest ETF market in Asia at about USD22.2 billion. In terms of turnover, Hong Kong is also the second-largest ETF market in Asia after Mainland China.2
There were 62 ETFs listed on the Stock Exchange of Hong Kong ("SEHK") as at the end of May 2010,3 an increase of 18 new ETFs since the beginning of this year. On the Mainland, there are currently 10 ETFs listed, an increase from six ETFs in January this year.4 Thus far, China's ETFs that are traded on the Shanghai and Shenzhen stock exchanges track only domestic markets. However, it is expected that, as domestic Mainland ETFs that track overseas markets are launched, this will allow domestic investors to broaden their exposure to international markets.
The growth potential could also be viewed from the perspective that many Asian ETFs have equity securities as their underlying product set. As more Asian investors embrace the ETF wrapper and markets continue to evolve, it would be reasonable to anticipate expansion beyond equity-based products, extending to other asset classes such as fixed income (other than government debt), commodities, hedge funds, currency and real estate. There is also an increasing investor demand for sector and thematic ETFs, especially those that provide exposure to Mainland Chinese equity strategies.
These developments point to the range of opportunities emerging in the ETF space in Asia. Global ETF managers would do well to develop or review their Asian and China strategy as an integrated part of their global expansion plans. With the current limited direct access to Mainland China's ETF market,5 this article discusses a few key issues for a successful pan-Asian strategy that features Hong Kong as the hub for expansion into the region. It provides a brief description of the typical approval process for an overseas ETF in Hong Kong, followed by an examination of various streamlined processes for overseas ETFs listed either in an "Acceptable ETF Regime" or a jurisdiction that has entered into a mutual recognition arrangement with Hong Kong. The relevant streamlined process can be comparatively more cost-efficient and less time-consuming than a typical application.
Gaining Market Entry to Hong Kong
Before it can conduct any form of public sales or subscriptions, an ETF in Hong Kong must apply to the Hong Kong Securities and Futures Commission ("SFC") for authorization and to the SEHK for listing. In a best-case scenario, it may take the SFC and SEHK about four months to approve these applications.
Application to the SFC
A collective investment scheme ("CIS") must be authorized by the SFC before it can be listed (and remain authorized by the SFC for so long as it is listed). As a CIS, an ETF is bound by the Code on Unit Trusts and Mutual Funds ("Code"). Appendix I of the Code contains the key requirements applicable to ETFs. Unless otherwise stated in the Code, ETFs must also comply with all applicable provisions in the Code, in particular, those governing index funds, as set out in Chapter 8.6 of the Code. When considering applications, the SFC will look into, among others, the following requirements:
- Underlying Index. In order to be accepted by the SFC, the underlying index tracked by an ETF must:
- have a clearly defined objective, and the market or sector it aims to represent should be clear;
- be broadly based (an index with a single constituent security weighing more than 40% or with its top five constituent securities weighing more than 75% would generally be considered too concentrated);
- be investible, in particular, the constituent securities of the index should be sufficiently liquid; and
- be transparent and published in an appropriate manner.
The SFC also requires the index provider of a relevant ETF to have possessed the expertise and technical resources to construct, maintain and review the methodology and rules of the index. With the implementation of the SFC's new revised Code from 25 June 2010, the underlying index will also be required to be objectively calculated and rules-based.
- ETF managers. Except for self-managed ETFs, fund managers must be approved by the SFC and, among other things:
- be engaged primarily in the fund management business;
- have sufficient financial resources, in particular have a minimum issued and paid-up capital and capital reserves of HK$1 million or its equivalent in foreign currency;
- not lend to a material extent; and
- maintain a positive net asset position at all times.
Application to SEHK
Concurrent with seeking authorization from the SFC, an ETF applicant must also apply to the Listing Division of the SEHK for listing. The Listing Division of the SEHK will normally grant a listing to an ETF applicant that has been authorized by the SFC. Chapter 20 of the Rules Governing the Listing of Securities on the Stock Exchange of Hong Kong Limited ("Listing Rules") sets out the timeline to be followed and documents to be submitted when applying for the SEHK's approval. In practice, it is recommended that ETF applicants consult the SEHK to obtain prior guidance on document preparation and submission early, in parallel with the process of seeking authorization from the SFC.
Acceptable ETF Regimes: Streamlined Recognition for U.S.-listed ETFs
An overseas ETF that meets the core structural and operational requirements under the Code and is governed by an "Acceptable ETF Regime" may seek SFC authorization by way of a streamlined recognition process. An overseas ETF may be listed in a number of jurisdictions. For the purposes of assessing the suitability of a jurisdiction as an "Acceptable ETF Regime", the focus is on the particular overseas jurisdiction where there is substantial interest in the ETF and in which it is primarily listed.
A number of regulatory principles will be considered in assessing an Acceptable ETF Regime, including: (i) the availability of a mutual co-operation and assistance agreement for fund management activities between the overseas jurisdiction's principal securities regulator and the SFC; and (ii) whether the overseas jurisdiction's overall securities regulatory framework is similar to Hong Kong's so as to afford investor protection comparable to that provided under Hong Kong law.
An ETF from an Acceptable ETF Regime is exempt from certain Code requirements, including specific criteria on the acceptability of the underlying index tracked by the ETF and content requirements for the ETF's financial reports.
The United States is currently the only Acceptable ETF Regime recognized by the SFC. Hong Kong can thus support execution of an effective go-to-market strategy for U.S.-listed ETFs and their managers. The present indications are that the SFC is unlikely to expand the category of Acceptable ETF Regime further. Going forward, the preferred mechanism for the SFC to expand market access would appear to be the use of a mutual recognition arrangement, discussed below.
Mutual Recognition Arrangements
The different Asian ETF markets are at different stages of development. The Asian fund regulatory environment as a whole is fragmented. There is no singular regional fund regulatory standard or commonly accepted fund structure that allows a fund already offered in one Asian jurisdiction to be passported for sale in another Asian jurisdiction without having to comply with additional regulations in the second jurisdiction.
In the absence of such a fund passport scheme (akin to the EU UCITS regime) or an analogous multi-lateral or regional response to support a pan-Asian distribution strategy, bilateral mutual recognition arrangements or similar cooperative agreements which facilitate cross-listings likely represent the next best alternative. These would allow an ETF to offer investor access across the region, build economies of scale and boost trading volumes, and, generally, extend market access.
With its ETF market size and turnover both significantly larger than those of competing listing platforms in the Asia ex-Japan market, and its geographic position as the gateway to Mainland China, Hong Kong is in a unique position.
Hong Kong has initially established mutual recognition arrangements with each of Taiwan, Australia and Malaysia. In essence, the various bilateral arrangements chart a course for mutual recognition so as to facilitate cross-listing and offering of ETFs in each of the relevant markets. The market anticipates that similar arrangements will be entered into with other regional regulators in the fullness of time. These arrangements are predicated on reciprocity and are inherently flexible for the SFC to offer targeted regulatory relief that can vary from jurisdiction to jurisdiction.
An ETF-specific framework was agreed with Taiwan on 22 May 2009. An approved ETF listed in Hong Kong or Taiwan and managed by asset managers licensed respectively by the SFC or the Financial Supervisory Commission in Taiwan ("FSC") will be mutually recognised in each other's jurisdiction for the purpose of cross-listings.
In principle, an ETF that is approved by the FSC and managed by a manager licensed and permitted under the relevant Taiwanese regulations will be deemed to have complied with the relevant provisions in the Code and generally will not be required to strictly observe its specific requirements, with certain exceptions. These exceptions pertain to: (i) appointment of a Hong Kong representative; (ii) dissemination of trading information by the ETF; (iii) disclosure in offering documents; (iv) advertising; (v) post-authorization requirements, including those on connected party transactions; and (vi) pricing error, financial reporting and notification requirements to investors, which must be complied with.
Likewise, an ETF which is authorized by the SFC and managed by an SFC licensed-manager will be deemed to have complied with the relevant provisions of the applicable Taiwanese regulations, with comparable exceptions pertaining to: (i) appointment of an agent; (ii) obtaining of approvals; (iii) information disclosure and reporting; and (iv) advertising and promotions.
The first Hong Kong ETF6 was approved for offering in Taiwan in July 2009. Two other Hong Kong ETFs7 were subsequently successfully listed on the Taiwan Stock Exchange. Together, these three Hong Kong ETFs have since their launch constituted a large proportion of the turnover, both in volume and value, in the Taiwan ETF market.8 The first Taiwan ETF to cross-list in Hong Kong did so in August 2009. The latter cross-listing in Hong Kong is by way of a feeder fund.9 This illustrates a situation where a direct cross-listing may not be practical because of the anticipated lower market demand. If so, a feeder structure may be considered. It is expected that more Taiwan ETFs will soon seek to list in Hong Kong.
An agreement was reached with Australia on 7 July 2008 whereby mutual recognition is extended to all authorized CISs (not just ETFs) that are regulated primarily by the SFC and managed by SFC-licensed managers, as well as Australian Securities and Investments Commission ("ASIC")-registered financial asset schemes except hedge funds.
Under the agreement, ASIC will exempt Hong Konglisted ETFs from the requirement of registration with ASIC and grant certain reliefs provided that: (i) these ETFs are not principally aimed at investors in Australia; and (ii) the relevant ETF, its manager and trustee have not been exempted from compliance with the relevant Hong Kong regulatory requirements due to their being regulated in some other jurisdiction. Additional reliefs are available to the manager and trustee if they satisfy certain entry and ongoing eligibility requirements.
Correspondingly, an ETF that is registered with ASIC and managed by an ASIC-licensed manager will automatically be authorized by the SFC on the basis that it has substantially complied with all the disclosure, operational and reporting requirements of the Code, provided that no more than 30% of the value of such an ETF is marketed to investors in Hong Kong, and subject to the possibility of additional regulatory requirements being imposed by the SFC.
An agreement was reached on 9 November 2009 between the SFC and the Securities Commission of Malaysia ("SC") that provides a framework for the mutual recognition of Islamic CIS (including Shariahcompliant ETFs) offered to the public. As a result, Islamic ETFs will be permitted to be offered, marketed and distributed in Malaysia if they are: (i) authorized and primarily regulated by the SFC; (ii) managed by an SFC-licensed manager; and (iii) domiciled in Hong Kong or a jurisdiction that has broadly implemented international IOSCO Principles 17 to 20 and is a signatory to the IOSCO Multilateral Memorandum of Understanding concerning consultation and cooperation and the exchange of information and have broadly implemental such measures.
Such ETFs are also required to comply with certain requirements under the SC's Guidelines for the Offering, Marketing and Distribution of Foreign Funds, including: (i) the appointment of a Shariah Supervisory Board/Shariah adviser; (ii) granting of nonexclusive jurisdiction to Malaysian courts to entertain any action concerning the relevant ETF; and (iii) main market listing requirements of the Malaysian stock exchange. Similarly, Islamic ETFs primarily regulated and approved by the SC and managed by SC licensees shall be deemed to have substantially complied with the SFC's authorization requirements save for certain exceptions.
Looking to the Future: Hong Kong is Central to an Asian ETF Strategy
The ETF markets in Asia (especially those in Hong Kong and Mainland China) are ready for further development. As Asian markets continue to expand, the speed and intensity of their growth is persuasive argument for foreign ETF managers to view their Asian expansion plans as part of an integrated strategy, rather than a combination of different initiatives. Hong Kong should be seen as central to any coherent Asian strategy to create new and sustainable sources of competitive advantage.
With its ETF market size and turnover both significantly larger than those of competing listing platforms in the Asia ex-Japan market, and its geographic position as the gateway to Mainland China, Hong Kong is in a unique position to intermediate between the large and steady stream of liquidity both inbound for Mainland China (from foreign investors wishing to tap investment opportunities in China) and outbound (from Mainland Chinese investors able to invest overseas via the Qualified Domestic Institutional Investor ("QDII") programme). Industry sources indicate that a mutual recognition arrangement between Hong Kong and Mainland China (similar to the existing arrangement between Hong Kong and Taiwan) is in the pipeline and may be established, possibly, as soon as late 2010. It is a distinct possibility that the ETF markets and regulatory regimes in all three jurisdictions (Hong Kong, Taiwan and Mainland China) may soon be liberalized and synchronized so as to create a "One China" or "Greater China" fund passport.
Hong Kong provides a compelling regional springboard for fund managers to launch and manage ETFs in Asia whether with a China theme or a more general Asian focus (with the potential to gain diversified exposure to multiple regional markets through one ETF).
1 "ETF Landscape Industry Review End of Q1 20120," ETF Research and Implementation Strategy, BlackRock, April 2010.
2 According to a speech (http://www.sfc.hk/sfc/doc/EN/ speeches/speeches/10/Alexa_20100608.pdf) given by Ms. Alexa Lam (Executive Director and Deputy Chief Executive Officer of the Hong Kong Securities and Futures Commission) in June 2010, average daily turnover for Hong Kong ETFs in 2009 increased by 13% from levels in 2008.
3 Please refer to http://www.hkex.com.hk/eng/prod/ secprod/etf/etfindex.htm.
5 Mainland China's legal regime does not currently allow foreign fund managers to directly participate in its ETF market. Some foreign fund managers have launched ETFs on the Mainland through joint venture alliances (in which foreign managers are permitted, subject to appropriate regulatory approvals, to hold up to a 49% interest in a joint venture asset management company) with Chinese domestic fund managers. To qualify as the foreign partner in such a joint venture, the foreign partner must: (i) be a financial institution experienced in managing financial assets; (ii) have sound financial status and good credit standing; (iii) be duly established in a jurisdiction with sound securities laws and an effective securities regulatory system, and whose securities regulator has entered into a Memorandum of Understanding with the China Securities Regulatory Commission; (iv) have adequate paid-up capital (approximately US$43.5 million); and (v) have a clean regulatory record (with no regulatory penalties imposed in the immediately preceding three years). The joint venture establishment will take about seven months in a best-case scenario.
6 W.I.S.E. Polaris CSI 300 Securities Investment Trust Fund.
7 Hang Seng H-Share Index ETF and Hang Seng Index ETF.
8 Ibid, 2.
9 Polaris Taiwan Top 50 Tracker Fund (HK).