Introduction
On 16 December 2019, the Securities and Futures Commission (“SFC”) first introduced in its circular a streamlined approach with regard to the authorization of index tracking feeder exchange traded funds (“ETF”) adopting a master-feeder structure (the “2019 Circular”). Since then, an SFC-authorized feeder ETF may invest its assets in an overseas-listed master ETF without SFC authorization when the requirements provided in the 2019 Circular are met. With a view to offer more investment choices to investors, the SFC has recently conducted a review and issued a supplemental circular on 25 February 2022 to further streamline the requirements for eligible ETFs adopting a master-feeder structure as set out in the 2019 Circular (the “Supplemental Circular”, and together with the 2019 Circular, the “Circulars”).
Background
In general, funds that are offered to the public in Hong Kong are subject to the prior authorization of the SFC pursuant to the Securities and Futures Ordinance (Cap. 571) (“SFO”) and the ETFs listed on The Stock Exchange of Hong Kong Limited are of no exception. The SFC’s Code on Unit Trusts and Mutual Funds (the “UT Code”) sets out the basic requirements that an SFC-authorized fund must comply with. It is provided under Chapter 7.12 of the UT Code that a fund will be authorized by the SFC as a feeder fund provided that it is investing 90% or more of its total net asset value in a single collective investment scheme which must be a master fund authorized by the SFC. This in turn means that an index-tracking ETF adopting a master-feeder structure would only be permitted if both the feeder ETF and the master ETF are authorized by the SFC.
However, with the procedures for obtaining SFC authorization being onerous and often expensive, many master ETFs already listed overseas, despite them having met the listing requirements in their respective home jurisdictions with long-standing establishments, could not nevertheless be used for setting up index-tracking ETFs adopting a master-feeder structure in Hong Kong due to the stringent requirements under the UT Code. As the industry has been asking for more flexibility in this regard, the SFC has, in the 2019 Circular which is now to be read together with the Supplemental Circular, offered to allow an SFC-authorized index tracking feeder ETF to invest its assets in an unauthorized overseas-listed master ETF if certain conditions are met.
General principles
According to the Circulars, the SFC authorization will be given on a case-by-case basis and taking into account the following two principles:
1. there are satisfactory safeguards and measures in place to address investor protection concerns; and
2. there are demonstrable benefits to the Hong Kong market, taking into account factors such as the size and significance of the master ETF, its track record and whether its underlying index is acceptable to the SFC.
Requirements
Master ETF
The master ETF should, at a minimum, meet the following key requirements pursuant to the Circulars:
1. the master ETF must be a scheme regulated in a recognized jurisdiction. Currently, schemes already in compliance in substance with certain provisions of the UT Code by virtue of prior authorizations obtained in recognized jurisdictions like Australia, France, Germany, Malaysia, Netherlands, Switzerland, Taiwan, Thailand, the UK and the USA are among those that are recognized by the SFC in this respect;
2. the master ETF must also be managed by a management company in an acceptable inspection regime or a scheme eligible under a mutual recognition of funds arrangement;
3. the master ETF, together with its management company and trustee/custodian, must have a good compliance record with the rules and regulations of its home jurisdiction and for the master ETF itself, the listing venue;
4. the master ETF must have a fund size of not less than USD 400 million and a track record of more than 1 year at the time of the feeder ETF’s listing on the Stock Exchange of Hong Kong. This requirement has been relaxed under the Supplemental Circular in contrast with the prior fund size and track record requirements of not less than USD 1 billion and more than 5 years respectively;
5. the master ETF must adopt physical replication of the underlying index through either a full replication or a representative sampling strategy; and
6. the master ETF’s engagement in securities financing transactions should not exceed 50% of its total net asset value unless there are comparable safeguards and disclosure.
Feeder ETF
An index tracking feeder ETF investing in an overseas-listed master ETF seeking SFC authorization in reliance on the streamlined approach for public offering in Hong Kong should meet the following requirements:
1. the feeder ETF must be a Hong Kong-domiciled ETF authorized by the SFC and be managed by a management company which is licensed or registered for Type 9 regulated activity and has a good compliance record;
2. the management company of the feeder ETF should report to the SFC as soon as practicable if the master ETF ceases to comply with the requirements set out in the Circulars and take appropriate remedial action to promptly rectify the situation; and
3. the management company of the feeder ETF should put in place appropriate arrangements to inform Hong Kong investors of any material change to, or event that has a significant adverse impact on, the master ETF in a timely manner.
In any event, the feeder ETF should also comply with the applicable requirements in the Overarching Principles Section and the UT Code, Investment-Linked Assurance Schemes and Unlisted Structured Investment Products and all other applicable regulatory requirements and guidelines as may be issued by the SFC from time to time.
Conclusion
As expressed by the SFC in the Circulars, the streamlined approach is expected to facilitate the growth of the Hong Kong ETF market while maintaining an appropriate level of investor protection. It is anticipated that, with the more relaxed regime now in place, greater flexibility is given to ETF issuers and asset managers to set up index-tracking ETF adopting a master-feeder structure that invests in an overseas-listed master ETF such that more investment choices could be offered in the Hong Kong market in which is to the benefit of retail investors.
