Recommending leveraged ETFs in HK

Fang Zhu prepared this case under the supervision of Dr. Rujing Meng for class discussion. This case is not intended to show effective or ineffective handling of decision or business processes. The authors might have disguised certain information to protect

confidentiality. Cases are written in the past tense, this is not meant to imply that all practices, organizations, people, places or

fact mentioned in the case no longer occur, exist or apply.

© 2018 by The Asia Case Research Centre, The University of Hong Kong. No part of this publication may be digitized, photocopied

or otherwise reproduced, posted or transmitted in any form or by any means without the permission of The University of Hong

Kong.

Ref. 18/615CC

Last edited: 13 October 2018

RUJING MENG FANG ZHU

A FINANCIAL ADVISOR’S CHOICE: RECOMMENDING LEVERAGED AND INVERSE

ETFS IN HONG KONG

Sarah Liu, a prominent financial advisor in a large Hong Kong investment bank, pondered

whether to recommend leveraged and inverse ETFs (L&I ETFs) to her clients. L&I ETFs

(called “L&I products” in Hong Kong as required by the Hong Kong Securities and Futures

Commission) provided leveraged or inverse exposure to Hong Kong, Asia Pacific, or overseas

indices to investors. First introduced in Hong Kong in June 2016, a total of 31 L&I ETFs had

debuted in the Hong Kong market by 7 February 2018. With L&I ETFs still new to Hong Kong,

many investors were ambivalent about investing in them. Enhanced liquidity and transparency

would increase investors’ appetite for these products, according to Sarah. In terms of risk, L&I

ETFs were riskier than traditional ETFs but less risky than derivative warrants (DWs), Callable

Bull Bear Contracts (CBBCs), futures, and options. The leverage factors of L&I ETFs in Hong

Kong were limited to 2 times and minus 1 time (2x and –1x), while the effective leverage factors

of DWs, CBBCs, futures, and options could be in the range of plus or minus 5 to 40 times. The

requirement for daily monitoring and rebalancing made L&I ETFs suitable for sophisticated

investors to hedge or speculate over the short term. As the global stock market plunged in early

February 2018, clients turned to Sarah to seek advice on choosing financial instruments to have

short-term hedging or speculation. Considering the increased market volatility and each client’s

specific background, Sarah needed to decide on the most suitable products for her clients.

Besides L&I ETFs, she was considering other alternatives, including DWs, CBBCs, traditional

ETFs, futures, or options.

Understanding L&I ETFs

Performance Calculation

Leveraged and inverse ETFs (L&I ETFs) were derivative products structured as exchange-

traded funds (ETFs). The products tracked the return of an underlying index on a daily basis,

HK1130

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and gave investors opportunities to pursue short-term market strategies.1,2 Unlike conventional

index-tracking ETFs, L&I ETFs aimed to deliver a multiple or the opposite of the index’s daily

return.3

Leveraged ETFs sought to deliver a daily return equivalent to a multiple of the return of the

underlying index. When an investor bought a two-time (2x) leveraged product, and the

underlying index moved up by 5% on a given trading day, the two-time leveraged product

should have delivered a gain of 10% on that day.4

Inverse ETFs sought to deliver the opposite of the daily return of the underlying index. When

an investor bought a one-time (–1x) inverse product, and the underlying index moved up by

5% on a given trading day, the inverse product should have delivered a loss of 5% on that day.5, 6 The multiple on the daily return, for example, 2x or –1x, was called the leverage factor of the

L&I ETFs.

Daily Investment Objective

L&I ETFs were designed for daily investment objectives. They were only suitable for investors

who actively monitored their holdings daily and responded rapidly when market conditions

changed. L&I ETFs were not suitable for long-term investing.7

The performance of L&I ETFs could deviate from the multiple or inverse of the underlying

index’s cumulative return when being held for longer than one day. This was due to the

compounding effects of daily returns.

In a fluctuating market and a holding period longer than one day, it was possible that leveraged

ETFs and the underlying index moved in opposite directions. It was also possible that inverse

ETFs suffered a loss when the underlying index stayed flat or even moved down. 8 [See

Appendix 1 for calculation examples showing the cumulative effects of daily compounding.]

Daily Rebalancing

L&I ETFs needed to rebalance their portfolio daily so that the leverage factor was maintained

at its target level. L&I ETFs were only expected to track the multiple or opposite return of the

underlying index for the rebalancing interval, i.e., one single trading day. It might not track the

multiple or opposite of the underlying return when it was held for less than a full trading day

or overnight.9 , 10 [See Appendix 2 for calculation examples showing how leverage factors

change during a trading day when the market moves.]

Aiming to achieve the stated investment goals daily, the leverage factor of L&I ETFs changed

as the market moved during one trading day.11 If an investor bought or sold an L&I ETF in the

1 HKEx, “Introduction to Leveraged and Inverse Products,” June 2016, http://www.hkex.com.hk/products/securities/exchange-

traded-products/overview?sc_lang=en, accessed 10 April 2018. 2 Narat Charupat and Peter Miu, “Leveraged Exchange-Traded Funds,” Springer Nature, 2016, accessed 4 October 2018. 3 “Understanding leveraged and Inverse products,” 2018, https://www.thechinfamily.hk/web/en/financial-

products/investment/leveraged-and-inverse-products/understanding-li-products.html, accessed 10 April 2018. 4 “Structured Products,” 2018, http://www.hantec.hk/sites/default/files/structured_products.pdf, accessed 4 October 2018. 5 “Understanding leveraged and Inverse products,” 2018. 6 “Structured Products,” 2018. 7 “Understanding leveraged and Inverse products,” 2018. 8 “Long-term Holding Risk,” 2018, https://www.thechinfamily.hk/web/en/financial-products/investment/leveraged-and-inverse-

products/long-term-holding-risk.html, accessed 10 April 2018. 9 The Chin Family, “Know more about daily rebalancing,” 2018, https://www.thechinfamily.hk/web/en/financial-

products/investment/leveraged-and-inverse-products/know-daily-rebalancing.html, accessed 10 April 2018. 10 “Structured Products,” 2018. 11 “Structured Products,” 2018.

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middle of a trading day, he might not be able to get the multiple or opposite of the return of the

underlying index until the next rebalancing. 12 [See Appendix 2 for calculation examples

showing trading an L&I ETF in the middle of a trading day.]

Tracking Difference and Tracking Error of L&I ETFs

The daily return of an L&I ETF might not track the multiple or the opposite of the underlying

index’s daily return perfectly due to practical reasons including supply and demand of the L&I

ETF in the market, trading costs and market frictions associated with tracking indexes, and

daily rebalancing of the L&I ETF. Therefore, daily tracking differences and tracking errors

were introduced as crucial performance metrics of L&I ETFs. A daily tracking difference was

defined as the difference between the daily return of an L&I ETF and the daily multiple or

opposite return of the underlying index. A tracking error was the volatility of the daily tracking

difference (measured by the standard deviation). It measured how consistently a L&I ETF

delivered the intended multiple or the opposite return of the underlying index.

Tracking difference could also be calculated over a holding period longer than one day. The

difference between the cumulative return of an L&I ETF and the multiple or opposite of the

cumulative return of the underlying index over a certain period was defined as the tracking

difference of the holding period. Generally, the tracking difference gradually increased with

the holding period becoming longer.

Use of Derivatives

L&I ETFs mainly invested in derivatives to realize its investment objective, i.e., to deliver the

daily target return based on the leverage factor. The derivatives that issuers of L&I ETFs used

as substitutes for directly investing in the underlying were principally swaps and futures,13, 14

For swap-based L&I ETFs, the issuer paid fees to the swap counterparties, and the swap

counterparties delivered to the issuer a multiple or the opposite of the return of the underlying

index daily. Swap-based L&I ETFs were exposed to the credit risk and counterparty risk of the

swap counterparties.15, 16, 17

For future-based L&I ETFs, the issuer achieved its investment goal by investing in future

contracts. There were transaction costs on trading futures. The future-based L&I ETFs were

exposed to risk that the performance of the futures might deviate from the desired performances

of the underlying.18, 19, 20

Cash balances arising from the use of derivatives were typically held in money market

instruments.

12 The Chin Family, “Trade L&I Products during a trading day,” 2018, https://www.thechinfamily.hk/web/en/financial-

products/investment/leveraged-and-inverse-products/trade-li-products.html, accessed 10 April 2018. 13 “Understanding leveraged and Inverse products,” 2018. 14 SFC, “Supplemental Circular on Leveraged and Inverse Products,” 23 December 2016,

http://www.sfc.hk/edistributionWeb/gateway/EN/circular/doc?refNo=16EC70, accessed 22 April 2018. 15 “Understanding leveraged and Inverse products,” 2018. 16 HSBC, “EXPLANATION OF RISKS FOR LISTED DERIVATIVES (INCLUDING LEVERAGED AND INVERSE

PRODUCTS) IN HONG KONG AND OVERSEAS MARKETS (For Personal Customer),” 2017,

https://www2.ebanking.hsbc.com.hk/1/PA_esf-ca-app- content/content/hongkong/pdf/investments/risks_for_listed_derivatives.pdf, accessed 24 April 2018.

17 “Structured Products,” 2018. 18 “Understanding leveraged and Inverse products,” 2018. 19 HSBC, “EXPLANATION OF RISKS FOR LISTED DERIVATIVES (INCLUDING LEVERAGED AND INVERSE

PRODUCTS) IN HONG KONG AND OVERSEAS MARKETS (For Personal Customer),” 2017. 20 “Structured Products,” 2018.

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Risk of L&I ETFs

L&I ETFs only targeted sophisticated investors who monitored the performance of their

portfolios on a daily basis. Before making investment decisions, investors had to be fully aware

of the risks involved in L&I ETFs. Major risk factors included long-term holding, rebalancing,

liquidity risks, leverage or short-selling risks, correlation risks, and credit risks. [See Appendix

3 for a detailed risk analysis.]

Development of L&I ETFs

The History of L&I ETFs

The market of exchange-traded funds (ETFs) experienced significant growth in terms of the

number and size of funds as well as trading volume, since the first ETF was launched in the

United States in 1993. Vanilla ETFs replicated a benchmarking market index, such as S&P 500,

and traded on an exchange like stocks. They offered investors exposure to the index in a more

flexible manner than conventional index mutual funds. As ETFs evolved, their scope widened

beyond index tracking. More complex ETFs emerged including L&I ETFs, offering investors

exposure to a multiple or the negative of the index return21.

In June 2006, ProFunds Group,22 a premier provider of alternative ETFs and mutual funds in

the United States issued the first 12 L&I ETFs tracking popular benchmarks like NASDAQ

100 and S&P 500.23 Since then, L&I ETFs grew substantially. By the end of June 2009, there

were about 120 L&I ETFs in US holding over USD300bn in assets.24, 25

Over time, L&I ETFs expanded to include funds that tracked more than just stock indices.

ProShares, an affiliation to ProFunds Group, offered various types of L&I ETFs on

commodities including crude oil, natural gas and silver; currencies including USD, euro, and

yen; and bonds.26 L&I ETFs had become a popular tool for investors to hedge their positions or

gain greater exposure to index movements.27 As such, they were among the most highly traded

securities on both US and major Asian stock exchanges.

Major issuers of L&I ETFs in the US were ProShares28 and Direxion.29 Their products tracked

the multiple (2x, 3x) or negative (–1x, –3x) of benchmarking indices such as the S&P 500,

21 C. A. Valle, N. Meade, and J.F. Reasley, “Exchange-traded funds: a market snapshot and performance analysis,” October

2014, http://people.brunel.ac.uk/~mastjjb/jeb/etf_final.pdf, accessed 10 April 2018. 22 ProFunds was a premier provider of alternative mutual funds, offering more than 100 funds. ProFund Advisors was founded in

1997, and together with its affiliates, ProShare Advisors and ProShare Capital Management, had over USD30bn in assets under management, as of 31 December 2017. “About ProFunds,” 2017, http://www.profunds.com/about.html, accessed 20

April 2018. 23 R. Wong and K. Hargadon, “Rebalancing Act: A Primer on Leveraged and Inverse ETFs,” 7 October 2009,

http://www.nera.com/content/dam/nera/publications/archive1/PUB_ETF_Leveraged_1009_web.pdf, accessed 10 April 2018. 24 E. Laise, “Subpoenas Put Pressure On ETFs With Twist,” 1 August 2009,

https://www.wsj.com/articles/SB124908326534498157, accessed 11 April 2018. 25 “Mazzilli: Leverage & Inverse ETFs Produce Outflows while TIPS Surge in July, 17 August 2009,

https://www.etf.com/sections/features/6342-mazzillis-musings.html?Itemid=7, accessed 28 August 2018. 26 Details of L&I commodity, currency and bond ETFs can be found on the “ETF Database,” http://etfdb.com, which contained

completed lists and information about L&I ETFs traded in the market. Lists of top Leveraged Equity ETFs can be found at:

http://etfdb.com/type/equity/all/leveraged/; top Inverse Equity ETFs can be found at http://etfdb.com/type/equity/all/inverse/. 27 J. Mulvey, “The Role Of Managed Futures And Commodities Funds,” 20 June 2012,

http://www.etf.com/publications/journalofindexes/joi-articles/12275-the-role-of-managed-futures-and-commodities-

funds.html?nopaging=1, accessed 10 April 2018. 28 ProShares was established in 2006 by the founders of ProFunds, a firm that was launched in 1997. ProShares was the largest

manager of L&I ETFs in the world, as of 31 December 2017. More information about Proshares can be found on https://www.investopedia.com/university/guide-to-etf-providers/proshares.asp and http://www.proshares.com/.

29 Direxion specialized on L&I ETFs. Founded in 1997, Direxion in 2008 became the first ETF provider to offer three times

leveraged ("triple-leveraged") ETF products that seek returns that are 300% (or -300% for Bear Funds) of the return of

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18/615C A Financial Advisor’s Choice: Recommending Leveraged and Inverse ETFs in Hong Kong

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NASDAQ 100, MSCI indexes, Dow Jones indexes, Russell 1000, and Russell 2000. Direxion

had also introduced leveraged and inverse replication of the NYSE Arca Gold Miners Index

and the Energy Select Sector Index.

L&I ETFs in Asia

The Emergence of L&I ETFs in the Asian Market

Being one of the industry’s pioneers, Samsung Asset Management 30 launched Asia’s first

leveraged ETFs in its home market, South Korea, in 2009. Since then, L&I ETFs had attracted

substantial interest and witnessed solid inflows in different markets across Asia.31

In 2012, the launch of the Next Funds Nikkei 225 Double Index ETF with about USD3bn in

assets and the Inverse Index ETF with about USD1bn in assets by Nomura marked the rapid

growth of the market for L&I ETFs in Japan.32 Similar to Japan’s overall ETF market, Japan’s

L&I ETFs mainly tracked domestic Japanese indices. By March 2017, the Japanese L&I ETFs

dominated with USD20bn for leveraged ETFs and USD3.4bn for inverse ETFs, respectively,

in monthly trading volume comparing with USD1.6bn for the conventional ETFs.33

The debut of the Yuanta Daily Taiwan 50 Bull 2x ETF34 and Yuanta Daily Taiwan 50 Bear –

1x ETF35 on the Taiwan Stock Exchange (TSE) in October 2014, tracking the TSEC (Taiwan

Stock Exchange Corporation) Taiwan 50 Index, marked the first L&I ETFs in the Greater China

region.36 Between October 2014 and March 2016, the trading volume of ETFs in Taiwan

increased over 40%, driven mainly by the demand for L&I ETFs.37 Following the successful

debut of its first two L&I ETFs, Yuanta launched various L&I ETFs tracking commodities38

and equity indices from mainland China (CSI300).39 Other Taiwanese funds including Fubon

Asset Management and Cathay Securities Investment Trust also issued various L&I ETFs

catering to the increasingly expanding market. By the end of February 2017, L&I ETFs in

Taiwan accumulated USD5.3bn in assets.40

their benchmark index for a single day. More information about Direxion can be found at

https://www.investopedia.com/university/guide-to-etf-providers/direxion.asp and http://www.direxioninvestments.com/. 30 An affiliate of Samsung Group, Samsung Asset Management in South Korea was a leading asset management firm founded in

1988. As of year 2017, it was the No.1 asset manager in Korea by AUM USD209.5bn. More information about Samsung

Asset Management can be found at http://www.eng.samsungfund.com/renewal/index.jsp. 31 “Samsung Asset Management's leveraged & inverse products open up world of investment opportunities to Hong Kong

investors,” 13 June 2016, http://www.scmp.com/presented/business/topics/li-products-now-available-hong-kong-

investors/article/1967991/samsung, accessed 14 April 2018. 32 Details for Next Funds Nikkei 225 Double Inverse Index ETF can be found at

http://www.morningstar.co.uk/uk/etf/snapshot/snapshot.aspx?id=0P00013MQ4. 33 T. Dennison, “Understanding how leveraging and rebalancing work,” The Journal of Investments &Pensions: Asia Asset

Management 22, no. 3 (March 2017), http://www.asiaasset.com/aam/2017-03/0317_PI.aspx, accessed 23 April 2018. 34 Details of Yuanta Daily Taiwan 50 Bull 2x ETF can be found at

http://www.morningstar.co.uk/uk/etf/snapshot/snapshot.aspx?id=0P00014IU3. 35 Details of Yuanta Daily Taiwan 50 Bear –1x ETF can be found at

http://www.morningstar.co.uk/uk/etf/snapshot/snapshot.aspx?id=0P00014IU4. 36 Adil Siddiqui, “First Leveraged ETF and Inverse ETF Launched on Taiwan Stock Exchange,”1 November 2014,

https://www.financemagnates.com/institutional-forex/exchanges/first-leveraged-etf-inverse-etf-launched-taiwan-stock-

exchange/, accessed 10 April 2018. 37 James Lord, “Leveraged and inverse ETF use on the rise in Asia,” 5 April 2016, https://www.etfstrategy.co.uk/leveraged-and-

inverse-etf-use-on-the-rise-in-asia-15121/, accessed 12 April 2018. 38 Yuanta S&P GSCI Gold 1x Inverse ER Futures ETF, Yuanta S&P GSCI Crude Oil 2x Leveraged ER Futures ETF, Yuanta

S&P GSCI Crude Oil 1x Inverse Futures ETF was launched in October 2016. Details can be found at: https://www.etfstrategy.co.uk/seven-inverse-leveraged-etfs-listed-in-taiwan-during-october-09876/.

39 Yuanta/P-shares CSI 300 2x Bull ETF, Yuanta/P-shares CSI 300 –1x BEAR ETF, Details can be found on Bloomberg:

https://www.bloomberg.com/quote/00637L:TT, https://www.bloomberg.com/quote/00638R:TT. 40 P. Zembrowski, “Leveraged and Inverse ETFs are a hit in Taiwan,” 6 April 2017, https://fundselectorasia.com/leveraged-

inverse-etfs-hit-taiwan/, accessed 23 April 2018.

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By the end of the year 2017, turnover of L&I ETFs was nine times that of conventional ETFs

in Japan, while in Taiwan it was three times higher. In South Korea, where L&I ETFs were

initially introduced in Asia, the products had 50% higher turnover than traditional ETFs.41

L&I ETFs in Hong Kong

Hong Kong’s regulator, the Securities and Futures Commission (SFC), was relatively cautious

with regard to launching L&I ETFs. It didn’t give the go-ahead to L&I ETFs until February

2016, and required market participants to use the product name “L&I products”42 rather than “L&I ETFs” to differentiate them from traditional ETFs, which passively tracked indices, and

to indicate its conservative attitudes toward L&I ETFs.43, 44 In addition, SFC required that the leveraged factor of L&I ETFs was subject to a cap. Leverage ETFs were subject to maximum

leverage factor of two times (2x), i.e., delivered a daily return equivalent to two times of the

daily return of the underlying index, and inverse ETFs were subject to a maximum leverage

factor of one time (–1x), i.e., no leverage at all.45, 46 Moreover, the SFC initially allowed only

L&I ETFs tracking “liquid and broadly based non-Hong Kong, non-mainland foreign equity

indices.” 47, 48

In June 2016, Samsung Asset Management launched L&I ETFs in the Hong Kong market by

listing the first batch of four L&I ETFs: Samsung KOSPI 200 Daily (2X) Leveraged Product,

Samsung KOSPI 200 Daily (–1X) Inverse Product, Samsung TOPIX Daily (2X) Leveraged

Product, and Samsung TOPIX Daily (–1X) Inverse Product.49 As their names indicated, the first

two provided exposure to South Korean equities, and the latter two tracked the Japanese stock

market.

In January 2017, the SFC allowed L&I ETFs to track local indices in Hong Kong.50 Three firms,

CSOP Asset Management from mainland China and Mirae Asset Global Investments and

Samsung Asset Management from South Korea responded by each listing four L&I ETFs in

March 2017. The products included 2x leveraged and –1x inverse ETFs tracking the Hang Seng

Index (HSI) and H-shares Index (HSCEI). The three firms also launched L&I ETFs tracking

overseas indices including TOPIX, S&P 500, NASDAQ 100, KOSPI 200, and Nifty 50.51 As

of 30 June 2017, there were 30 L&I ETFs listed in Hong Kong. Seventeen of them tracked

Hong Kong indices. These seventeen L&I ETFs accounted for approximately 10% of the

average daily turnover (ADT) of the Hong Kong ETF market and around 1.2% of the total

market capitalization by June 2017. In addition, five of the 10 most actively traded ETFs in

41 T. Dennison, “Understanding how leveraging and rebalancing work,” The Journal of Investments &Pensions: Asia Asset

Management 22, no 3 (March 2017),, http://www.asiaasset.com/aam/2017-03/0317_PI.aspx, accessed 23 April 2018. 42 In this case, we still used the term “L&I ETFs” for L&I Products in Hong Kong for the consistency with international practice. 43 T. Dennison, “Understanding how leveraging and rebalancing work.” 44 To be consistent with the term used in the international market, we use the term “L&I ETFs” for L&I products in Hong Kong

throughout the case. 45 SFC, “Circular to Licensed Corporations and Registered Institutions Providing Services to Clients with respect to Leveraged

and Inverse Products,” 5 February 2016, http://www.sfc.hk/edistributionWeb/gateway/EN/circular/doc?refNo=16EC6,

accessed 22 April 2018. 46 “Structured Products,” 2018. 47 SFC, “Circular to Licensed Corporations and Registered Institutions Providing Services to Clients with respect to Leveraged

and Inverse Products.” 48 SFC, “Supplemental Circular on Leveraged and Inverse Products,” 23 December 2016,

http://www.sfc.hk/edistributionWeb/gateway/EN/circular/doc?refNo=16EC70, accessed 22 April 2018. 49 “Hong Kong sees first leveraged and inverse exchange-traded funds amid volatile market,” 13 June 2016,

http://www.scmp.com/business/companies/article/1974617/hong-kong-sees-first-leveraged-and-inverse-exchange-traded-

funds, accessed on 23 April 2018. 50 I Wong, “HK allows broader use of indices for L&I ETFs,” 29 December 2016, https://fundselectorasia.com/hk-allows-

broader-indices-etfs/, accessed 24 April 2018. 51 “Hong Kong sees first leveraged and inverse exchange-traded funds amid volatile market,” 13 June 2016,

http://www.scmp.com/business/companies/article/1974617/hong-kong-sees-first-leveraged-and-inverse-exchange-traded-

funds, accessed 23 April 2018.

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18/615C A Financial Advisor’s Choice: Recommending Leveraged and Inverse ETFs in Hong Kong

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Hong Kong were L&I ETFs tracking Hong Kong indices. 52 By the end of 2017, the SFC still

did not allow L&I ETFs tracking mainland China-related indices. [See Exhibit 1 for a list of

L&I ETFs in Hong Kong market.]

A Financial Advisor’s Decision

Market Environment in Early February 2018

The global equity market plunge at the beginning of February 2018 began when the US Labor

Department reported an unexpected yet long-awaited jump in average hourly earnings.53 The

reported jump in workers’ wages surprised economists and triggered worries that higher

inflation might be on the way. As a result, the Federal Reserve would be likely to raise interest

rates to curb inflation. Higher rates would push up firms’ financing costs and dampen economic

growth.54

At the start of year 2018, stocks jumped on the assumption that corporate profits would keep

rising and the global economy would keep strengthening. 55 However, the plunge of stock

markets marked a sharp turnaround, and early February 2018 witnessed strong volatility.56 The

US markets plunged on 5 February 2018. The S&P 500 saw a drop of 4%. At the end of that

trading day, Dow Jones industrials were off 1175 points, poised at its worst one-day point drop

in history.57 By the end of 5 February 2018, all the major US stock market sectors had lost

ground, with considerable weakness in the energy, financial, and health-care sectors.

Markets outside the US fell on 6 February 2018. The FTSE100 in London experienced its

biggest slump since the Brexit vote, falling by 2.6%. Japan’s Nikkei 225 index skidded 6.1%

by early afternoon of 6 February 2018. Australia’s benchmark S&P ASX 200 declined 3.3%.

South Korea’s KOSPI dropped 2.9%, and Shanghai Composite index was off by 2.2%.58, 59 HSI

in Hong Kong was down 4.94%, or 1593.91 points by the lunch hour break on 6 February 2018.

The drop was the biggest single-day percentage drop since August 2015. The Hang Seng China

Enterprises Index lost 6.10%, its biggest drop in seven years.60

After the global market slump on 5 February and 6 February 2018, volatilities soared to levels

that were not seen since the 2007–2008 financial crisis.61 The atmosphere was one not seen

since the latter days of the financial crisis, during when the mood of many investors switched

from optimistic to extra cautious.

52 “Research Paper on Hong Kong ETF Market and Topical Issues in the ETF Space,” 16 January 2018,

https://www.sfc.hk/web/EN/files/PCIP/Research/Research%20Paper_20180116.pdf, HK SFC, accessed 4 August 2018. 53 “Job growth up 200,000 in January, better than expectations, and wages up,” 2 February 2018,

https://www.cnbc.com/2018/02/02/nonfarm-payrolls-jan-2018.html, accessed 25 April 2018. 54 “Stocks close down, making February the worst month in two years for the market,” 28 February 2018,

http://www.latimes.com/business/la-fi-financial-markets-20180228-story.html, accessed 25 April 2018. 55 Ibid.. 56 Ibid. 57 Jeff Cox, “Why the stock market plunged Monday?,” CNBC, 5 February 2018, https://www.cnbc.com/2018/02/05/why-the-

stock-market-plunged-today.html, accessed 7 May 2018. 58 “Closing summary,” The Guardian, 7 February 2018, https://www.theguardian.com/business/live/2018/feb/06/stock-market-

turmoil-europe-ftse100-heavy-losses-asia-us-dow-jones-live-updates, accessed 5 May 2018. 59 “Australian and Asian stock markets slide after Dow suffers biggest one-day points fall –as it happened,” The Guardian, 6

February 2018, https://www.theguardian.com/business/live/2018/feb/05/stock-markets-slide-global-sell-off-service-sector-

bitcoin-business-live?page=with:block-5a792d7ee4b0e24fb75218f2#block-5a792d7ee4b0e24fb75218f2, accessed 4 May

2018. 60 “Hang Seng Index plunges 1600 points amid ‘panic selling’, as fear sweeps city after US market rout,” 6 February 2018,

http://www.scmp.com/business/markets/article/2132166/hong-kong-traders-brace-market-plunge-after-us-stocks-meltdown, accessed 19 May 2018.

61 Jeff Cox, “The stock market correction two weeks later: How it happened, and if it can happen again,” CNBC, 16 February

2018, https://www.cnbc.com/2018/02/16/the-stock-market-correction-two-weeks-later.html, accessed 13 July 2018.

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Sarah’s Thoughts on L&I ETFs

Sarah Liu was a brilliant, determined, and knowledgeable financial advisor working at a major

investment bank in Hong Kong. After obtaining her bachelor’s degree in finance at a prominent

university in mainland China, Sarah came to Hong Kong for graduate studies and completed

her master’s degree in financial mathematics. She had excellent quantitative skills as well as an

in-depth understanding of financial economics.

Sarah joined the bank after finishing her master’s and served as a financial advisor for almost

two years. During this time, she acquired practical experiences and gradually established

credibility among clients with various investment purposes.

In early February 2018, Sarah was pondering whether to recommend L&I ETFs to clients who

were experienced investors. The targeted clients traded on a daily basis, and always responded

promptly to market movements. Under the given market condition, they looked to actively

hedge their portfolios or speculate on further market trends.

During 2017, the US stock market continued its nine-year bull run, and the Hong Kong HSI

rose about 36%. Given the worldwide economic and political instabilities, Sarah wondered if

the significant market tumble was just a bull-market correction or the beginning of a crash.

Sarah was also aware of the potential issues and challenges when recommending the L&L ETFs

to her clients. She had to take into account the complexity of the products, potential legal issues,

relevant regulations, and the availability of competing financial products offered in Hong Kong.

Potential Legal Issues and Regulations

Recommending L&I ETFs to clients could be potentially challenging. In the US, the Financial

Industry Regulatory Authority (FINRA) had issued a regulatory notice reminding firms of their

sales practice obligations in connection with L&I ETFs. In particular, recommendations to

customers had to be suitable and based on a full understanding of the terms and features of the

product recommended; sales materials related to leveraged and inverse ETFs had to be fair and

accurate; and firms had to have adequate supervisory procedures in place to ensure that these

obligations were met.62 In addition, FINRA warned investors of L&I ETFs of extra risks when

holding the products over time.63

The SFC in Hong Kong also had special requirements on the product name, structure,

experience of the management company, and market-making arrangements of the L&I ETFs.64

The regulator clearly stated that to produce the specified leveraged or inverse return, these

products had to rebalance their portfolios typically on a daily basis. In addition, the SFC stated

clearly in its Circular on Leveraged and Inverse Products that L&I ETFs were derivative

products, and intermediaries needed to observe all the applicable requirements under the Code

of Conduct for Persons Licensed by or Registered with SFC. Moreover, the SFC required

intermediaries to put in place appropriate measures, such as providing training to staff to ensure

that they were familiar with the risks and features of the investment products and complied with

the applicable requirements when serving their clients.65

62 “Regulatory Notice 09-31,” June 2009, http://www.finra.org/sites/default/files/NoticeDocument/p118952.pdf, accessed 2 July

2018. 63 “Investors Alert,” 18 August 2009, http://www.finra.org/investors/alerts/leveraged-and-inverse-etfs-specialized-products-

extra-risks-buy-and-hold-investors, accessed 2 July 2018. 64 SFC, “Supplemental Circular on Leveraged and Inverse Products,” 23 December 2016,

http://www.sfc.hk/edistributionWeb/gateway/EN/circular/doc?refNo=16EC70, accessed 22 April 2018. 65 HKEx website, https://www.hkex.com.hk, accessed 4 August 2018.

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Failing to explain the features, investment objectives, and suitability of L&I ETFs to the clients

could result in severe consequences for the wealth management company. In the US, Morgan

Stanley settled a penalty of USD8mn for unsuitable –1x inverse ETF sales on 14 February 2017

in addition to losing clients. The SEC stated that Morgan Stanley had “recommended securities

with unique risk and failed to follow its policies and procedures to ensure they were suitable

for all clients.” Morgan Stanley solicited clients to purchase –1x inverse ETFs in retirement and

other accounts that were meant for long-term investment. But over longer periods of time, the

inverse ETFs’ performances differed dramatically from the opposite of their benchmarks,

which led to significant losses for the clients’ portfolios.66 Among other compliance failures,

SEC found that Morgan Stanley did not monitor the inverse ETF positions on an ongoing basis.

Morgan Stanley was penalized for not properly disclosing the risk or not considering the

appropriateness of the products for clients.67

Sarah was fully informed that by selling L&I ETFs, she was obliged to state clearly about

investment objectives and interests, risk tolerance, suitability to the clients.

Other Popular Competing Products Offered in Hong Kong

Sarah was also mindful that there were other financial products listed in Hong Kong that offered

investors exposure to a multiple or the negative of the index return. Before the emergence of

L&I ETFs, leveraged or inverse exposure of major indices had been available through futures,

options, DWs, Callable Bull Bear Contracts (CBBCs), or even some closed-end mutual funds

for decades.68

With a margin account, high-leveraged long or short positions could be held on equity indices

through futures. With a movement of the index, the corresponding change of the future contract

was known exactly. When a large, unfavorable movement of the underlying index occurred,

investors in future contracts would suffer margin calls.

Options were an alternative choice for investors to hold leveraged long or short positions;

however, the guaranteed exposure was exclusively on one side of the market. Besides, options

were generally less liquid and involved higher transaction costs than futures and ETFs. In

addition, the “time decay” of option premiums added to the shortcomings of investing in

options.69

Being a popular listed structured product on the Hong Kong Stock Exchange (HKEX), DWs70

were an instrument that gave an investor the right to “buy” or “sell” an underlying asset at a

preset price before a specified expiration date. They might be bought and sold before their

expiration in the market provided by HKEX. The underlying asset of DWs covered a range of

assets, including Hong Kong stocks, Hong Kong stock indices, overseas stocks, overseas stock

indices, currencies, and commodities. In Hong Kong, DWs were issued by a third party, usually

an investment bank, independent of the issuer of the underlying assets. They normally had an

initial life of six months to two years and were settled in cash only. DWs, similar to L&I ETFs,

66 “Morgan Stanley settles charges related to ETF investments,” SEC press release, 14 February 2017,

https://www.sec.gov/news/pressrelease/2017-46.html. accessed 7 May 2018. 67 “Morgan Stanley to pay $8 million penalty in unsuitable single inverse ETF sales, customer losses,” 14 February 2017,

http://www.stocklaw.com/Securities-Fraud-Blog/2017/February/Morgan-Stanley-to-Pay-8-Million-Penalty-in-Unsui.aspx,

accessed on 6 May 2018. 68 T. Dennison, “Understanding how leveraging and rebalancing work.” 69 More information about options can be found at “Options,” 2018, https://www.investopedia.com/terms/o/option.asp, accessed

24 April 2018. 70 HKEx website, https://www.hkex.com.hk, accessed 22 August 2018.

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were also easier for individuals to access as they were sold like stock shares on HKEX, and

investors did not need a margin account to trade them.

Another listed structure product, CBBCs,71 tracked the performance of an underlying asset

without requiring investors to pay the full price required to own the actual asset. They were

issued either as bull or bear contracts with a fixed expiry date, allowing investors to take bullish

or bearish positions on the underlying asset.72 The types of the underlying asset of CBBCs were

fewer than that of DWs, including Hong Kong stocks, Hong Kong stock indices, and overseas

stock indices. CBBCs were issued by a third party in Hong Kong, usually an investment bank,

independent of HKEX. In Hong Kong, CBBCs might be issued with a lifespan of three months

to five years and were settled in cash only. CBBCs were also easier for individuals to access as

they were sold like stock shares on HKEX and investors did not need a margin account to trade

them. CBBCs were issued with the condition that during their lifespan they could be called by

the issuers when the price of the underlying asset reached a level known as the “Call Price”

specified in the listing document. If the Call Price was reached before expiry, the CBBC would

expire early and the trading of that CBBC would be terminated immediately.

Compared to alternative products, L&I ETFs were suitable for capturing short-term movements

in an index with a lower embedded leverage, for the purpose of either hedging or speculation.

Comparing with futures and options, L&I ETFs had he following three advantages:73

 Lot sizes for L&I ETFs were generally smaller.

 L&I ETFs were exchange listed. Investors didn’t need a margin account to trade them.

Trading L&I ETFs was simply like trading stocks.

 Unlike a future’s margin, investors of L&I ETFs were guaranteed not to lose more than

the purchase price. The potential losses associated with L&I ETFs were only limited to

the initial capital invested and investors would not receive margin calls even if the

underlying index value dropped and increased sharply. In addition, some accounts that

were not allowed to use leverage and/or short sales might use L&I ETFs to accomplish

the same purpose.

 If the index trended in the investor’s favor for several days, the increased exposure from

the daily rebalancing activity would outweigh any decay.

Compared with DWs and CBBCs, L&I ETFs had lower leveraging in general. In addition, the

impacts of implied volatility, time decay, and mandatory call also made DWs and CBBCs much

riskier than L&I ETFs. [See Exhibit 2 for a comparison of L&I ETFs, DWs, and CBBCs by

the major dimensions including underlying, leverage factor, duration, funding costs, liquidity,

and various aspects of risk.]

The Clients

Sarah held the view that the market would correct further in 2018, so she was considering

whether to recommend inverse ETFs to her clients as a hedge for the downside risks. Three

retail clients came to Sarah to fulfill their market perspectives and investment goals.

71 Ibid. 72 “Other Risk Disclosure Statement,” 2018, http://www.eif.com.hk/images/stories/pdf/Other_Risk_Disclosure_Statement.pdf,

accessed 4 October 2018. 73 T. Dennison, “Understanding how leveraging and rebalancing work.”

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Client 1:

Jack Lee was a high-net-worth individual who held USD1mn in liquid financial assets. Jack

was in his late 30s; after completing his graduate study at a top Hong Kong university, he had

started to take more active roles in his family’s business.

Jack’s current portfolio contained heavy weighted index products on equity exposure to the

Hong Kong market, and he wanted to hedge for downside risks. He had market views similar

to Sarah’s, believing that the HSI would drop further in the short term. However, he was not

willing to use high leverage. He was also reluctant to hold margin accounts for short-selling as

he wanted like to limit the potential loss to what he had invested. In addition, Jack was open to

keep the hedging position over a few months. He planned to decide whether to close the hedging

position based on the analysis of the market on a day-to-day basis.

Client 2: After receiving a sizable inheritance, Rick Chan had become wealthy overnight. Rick had

graduated from a university in Hong Kong three years ago. He held double degrees in law and

economics and worked as an Executive Officer for the Hong Kong government.

Rick believed that the worldwide equity market was oversold and currently it was a good

opportunity to speculate. He was especially interested in buying Chinese internet stocks and

had a large existing exposure to Tencent stock (0700.HK).

Client 3:

Lynn Lai was in her late 50s. She was an experienced investor and had been doing business

with Indian companies for years. She was holding a portfolio that had large equity exposure to

India. She believed that the global market would continue to fall in the short term and wanted

to select a product that could hedge her Indian equity exposure over a three- to six-month

horizon. In the meantime, Lynn did not want to trade futures or directly short ETFs tracking

Indian stocks, as she was unwilling to open margin accounts or expose herself to potential

margin call risks.

Sarah’s Decisions

Sarah’s three clients had different market outlooks and different portfolios. She had scheduled

to meet each client in the coming few days. As part of her quest to find the best product for her

clients, Sarah had collected market data about relevant L&I ETFs and competing products,

including DWs and CBBCs. [Exhibit 3 contains market data for available inverse ETFs, DWs

(put), and CBBCs (bearish) tracking the HSI. Exhibit 4 lists ETFs tracking Chinese internet

stocks available in Hong Kong and the US. Exhibit 5 lists ETFs tracking Indian stock indices

in Hong Kong and the US.] Sarah was fully aware that she needed to analyze various factors

and combine her own market views with the characteristics (age, educational backgrounds,

future investment goals, etc.) of each individual client to come up with tailor-made

recommendations.

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EXHIBIT 1. LIST OF LEVERAGED AND INVERSE ETFS IN HONG KONG MARKET

Ticker74 Name

7221 ChinaAMC Direxion Hang Seng Index Daily 2x Leveraged Product

7321 HK Equity ChinaAMC Direxion Hang Seng Index Daily -1x Inverse Product

7261 ChinaAMC Direxion NASDAQ-100 Daily 2x Leveraged Product

7331 HK Equity ChinaAMC Direxion NASDAQ-100 Daily -1x Inverse Product

7331 T2 Equity ChinaAMC Direxion NASDAQ-100 Daily -1x Inverse Product

7267 ChinaAMC Direxion Hang Seng China Enterprises Index Daily 2x Leveraged Product

7341 HK Equity ChinaAMC Direxion Hang Seng China Enterprises Index Daily -1x Inverse Product

7200 CSOP Hang Seng Index Daily 2x Leveraged Product

7300 HK Equity CSOP Hang Seng Index Daily -1x Inverse Product

7202 CSOP Nifty 50 Daily 2x Leveraged Product

7335 HK Equity CSOP Nifty 50 Daily -1x Inverse Product

7335 T2 Equity CSOP Nifty 50 Daily -1x Inverse Product

7288 CSOP Heng Seng China Enterprises Index Daily 2x Leveraged Product

7388 HK Equity CSOP Hang Seng China Enterprises Index Daily -1x Inverse Product

7242 E Fund Yuanta Hang Seng Index Daily 2x Leveraged Product

7302 HK Equity E Fund Yuanta Hang Seng Index Daily -1x Inverse Product

7222 Mirae Asset Horizons S&P 500 Daily 2X Leveraged Product

7322 HK Equity Mirae Asset Horizons S&P 500 Daily -1X Inverse Product

7322 T2 Equity Mirae Asset Horizons S&P 500 Daily -1X Inverse Product

7225 Mirae Asset Horizons Topix Daily 2X Leveraged Product

7315 HK Equity Mirae Asset Horizons Topix Daily -1X Inverse Product

7315 T2 Equity Mirae Asset Horizons Topix Daily -1X Inverse Product

7230 Mirae Asset Horizons Hang Seng China Enterprises Index Daily 2x Leveraged Product

7362 HK Equity Mirae Asset Horizons Hang Seng China Enterprises Index Daily -1x Inverse Product

7231 Mirae Asset Horizons Hang Seng Index Daily 2x Leveraged Product

7336 HK Equity Mirae Asset Horizons Hang Seng Index Daily -1x Inverse Product

7205 Samsung HSI Daily 2X Leveraged Product

7312 HK Equity Samsung HSI Daily -1X Inverse Product

7228 Samsung HSCEI Daily 2X Leveraged Product

7328 HK Equity Samsung HSCEI Daily -1X Inverse Product

7250 Samsung KOSPI 200 Daily 2X Leveraged Product

7326 HK Equity Samsung KOSPI 200 Daily -1X Inverse Product

7255 Samsung TOPIX Daily 2X Leveraged Product

7311 HK Equity Samsung TOPIX Daily -1X Inverse Product

7210 XIE Shares Chimerica FTSE N Share Daily 2x Leveraged Product

Source: Bloomberg, as of 7 February 2018.

74 The difference between the HK Equity and T2 Equity with the same security code was the settlement date. The settlement date

of T2 Equity was two trading days later than the transaction date (T+2) and that of HK Equity was the same as the transaction

date (T+0).

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EXHIBIT 2. COMPARISON OF L&I ETFS, DWS, AND CBBCS As three popular short-term investment tools available in Hong Kong market, we compared

L&I ETFs with derivative warrants (DWs) and CBBCs:

L&I ETFs DWs CBBCs

UNDERLYING Stock indices (HSI,

HSCEI, S&P500,

NASDAQ100, TOPIX,

KOSPI 200. Nifty 50,

FTSE China N Share All

Cap Capped)

Hong Kong Stocks, Hong

Kong stock indices,

overseas stocks,

overseas stock indices,

currencies and

commodities

Hong Kong stocks,

Hong Kong stock

indices and overseas

stock indices

LEVERAGE FACTOR 2x for leverage ETFs

and -1x for inverse

ETFs

5x to 40x positive or

negative of the

underlying return

5x to 40x positive or

negative of the

underlying return

INTENDED HOLDING PERIOD Short term Short term Short term

DURATION Daily rebalanced Pre-determined expiries Pre-determined

expiries

TIME DECAY No time decay the option premium

diminished over time

the option premium

diminished over time

MANDATORY CALL RISK No No Yes

MAJOR FACTOR FOR PRICE

MOVEMENT

underlying price underlying price and

implied volatility

underlying price

FUNDING COSTS the cost (fees and

ongoing charges) was

transparent

complicated and

decided by issuers

complicated and

decided by issuers

ISSUER AND COUNTERPARTY

RISK

the underlying assets

were kept separately

by trustees

investors were exposed

directly to issuer’s

counterparty risk

investors were exposed

directly to issuer’s

counterparty risk

LIQUIDITY High turnover The second market

might be limited: the

liquidity provider might

be the only market

participant for a

particular warrant, as a

result it could be harder

for investors to realize

the value of the warrant

before it expired

The second market

might be limited: the

liquidity provider might

be the only market

participant for a

particular CBBC, as a

result it could be

harder for investors to

realize the value of the

CBBC before it expired

Source: “knowledge about L&I products,” July 2016, http://www.csopasset.com/landi/nifty/en/ ,

accessed 25 April 2018); https://www.hkex.com.hk/-/media/HKEX-

Market/Products/Securities/Derivative-Warrants/Industry-Principles-on-Liquidity-Provision-

for-Listed-Structured-Products/principle.pdf.

Prepared by author.

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List of Eligible Underlying for DWs Issuance (1st quarter 2018, effective from 5 February 2018)

Hong Kong Stocks

As the list of eligible single Hong Kong stocks for DWs issuance is quite long, It is provided in the worksheet “DWs Underlying Single Stocks” in the accompanying

case spreadsheet "L&I ETFs in HK_Data.xlsx”

Hong Kong Stock Indices

Hang Seng Index (HSI) Hang Seng China Enterprises Index (HSCEI)

Foreign Stock

Apple Inc. Google Inc.

Alibaba Group Holding Limited

Foreign Indices

Dow Jones Industrial Average Index KOSPI 200 Index

MSCI Taiwan Index Nasdaq 100 Index

Nikkei 225 Stock Average Index

Currency

British Pound Sterling / US Dollar New Zealand Dollar / US Dollar

US Dollar / Australian Dollar US Dollar / Japanese Yen

US Dollar / Euro US Dollar / offshore Renminbi (CNH)

US Dollar / Canadian Dollar

Commodities

Oil Futures Contract Gold

Platinum Silver

Source: HKEx, https://www.hkex.com.hk/?sc_lang=en, as of 7 February 2018.

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List of Eligible Underlying for CBBC Issuance (1st quarter 2018, effective from 5 February 2018)

Hong Kong Stocks

Stock Code Name of Company 5 HSBC Holdings plc

27 Galaxy Entertainment Group Ltd.

175 Geely Automobile Holdings Ltd.

386 China Petroleum & Chemical Corporation - H Shares

388 Hong Kong Exchanges and Clearing Ltd.

700 Tencent Holdings Ltd.

763 ZTE Corporation - H Shares

857 PetroChina Co. Ltd. - H Shares

883 CNOOC Ltd.

939 China Construction Bank Corporation - H Shares

941 China Mobile Ltd.

981 Semiconductor Manufacturing International Corporation

1211 BYD Co. Ltd. - H Shares

1299 AIA Group Ltd.

1336 New China Life Insurance Co. Ltd. - H Shares

1398 Industrial and Commercial Bank of China Ltd. - H Shares

1918 Sunac China Holdings Ltd.

2007 Country Garden Holdings Co. Ltd.

2018 AAC Technologies Holdings Inc.

2318 Ping An Insurance (Group) Co. of China Ltd. - H Shares

2382 Sunny Optical Technology (Group) Co. Ltd.

2601 China Pacific Insurance (Group) Co., Ltd. - H Shares

2628 China Life Insurance Co. Ltd. - H Shares

2800 Tracker Fund of Hong Kong

2822 CSOP FTSE China A50 ETF

2823 IShares FTSE A50 China Index ETF

2828 Hang Seng H-Share Index ETF

3333 China Evergrande Group

3968 China Merchants Bank Co., Ltd. - H Shares

3988 Bank of China Ltd. - H Shares

Hong Kong Stock Indices

Hang Seng Index

Hang Seng China Enterprises Index

Hang Seng China H-Financials Index

Overseas Stock Indices

Dow Jones Industrial Average

MSCI Taiwan Index

Nikkei 225 Stock Average Index

NASDAQ-100 Index

Source: HKEx, https://www.hkex.com.hk/?sc_lang=en, as of 7 February 2018.

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EXHIBIT 3. INVERSE ETFS, DWS (PUT), AND CBBCS (BEARISH) TRACKING HSI IN HONG KONG MARKET

List of Inverse ETFs tracking HIS

SECURITY CODE

ISSUER LEVERAGE FACTOR

AUM (HKD MN)

TRADING VOLUME (SHARE)

TOTAL EXPENSE RATIO*

MANAGE MENT FEES

CLOSING PRICE

NAV PER

UNIT

7300 CSOP -1x 778.83 60,627,800 - 0.99% 5.40 5.4086

7321 ChinaAMC -1x 166.90 644,900 1.51% 0.99% 5.99 6.0037

7302 E Fund Yuanta

-1x 153.62 272,300 - 0.80% 4.78 4.8005

7312 Samsung -1x 120.73 1,642,200 1.30% 0.65% 4.51 4.5218

7336 Mirae Asset

-1x 79.12 1,903,500 1.28% 0.65% 5.64 5.6516

Source: Bloomberg, as of 7 February 2018.

*: “–” means there is no expense ratio reported for the funds.

Additional market data are given in the worksheet “HSI and Its Inverse ETFs” of the

accompanying case spreadsheet “L&I ETFs in HK_Data.xlsx” for each inverse product tracing

HSI index.

There were more than 700 DWs (put) and CBBCs (bearish) tracking HSI listed in HKEX as of

7 February 2018. The major issuers of the contracts included Hang Seng Bank, Goldman Sachs,

JP Morgan, Societe Generale, UBS AG, BNP, Credit Suisse, Vontobel, and other investment

banks, and the effective gearing of DWs (put) and CBBCs (bearish) ranged from –5x to –40x.

The effective gearing of DWs (put) and CBBCs (bearish) were much higher than the leverage

factor of inverse ETFs (–1x).

Effective Gearing of DWs (Put) tracking HSI listed in Hong Kong Market

MAJOR ISSUER EFFECTIVE GEARING

HANG SENG BANK -10x - -40x

GOLDMAN SACHS -5x - -40x

JP MORGAN -5x - -35x

SOCIETE GENERALE -10x - -20x

UBS AG -10x - -30x

VONTOBEL -10x - -40x

Source: HKEx and Bloomberg, as of 7 February 2018.

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Effective Gearing of CBBCs (Bearish) tracking HSI listed in Hong Kong Market

ISSUER EFFECTIVE GEARING

HANG SENG BANK -5x - -12x

GOLDMAN SACHS -9x - -18x

JP MORGAN -5x - -18x

SOCIETE GENERALE -5x - -18x

UBS AG -5x - -18x

BNP PARIBAS -9x - -14x

CREDIT SUISSE -8x – 22x

VONTOBEL -10x - -18x

Source: HKEx and Bloomberg, as of 7 February 2018.

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EXHIBIT 4. ETFS TRACKING CHINESE INTERNET STOCKS OFFERED IN HONG KONG AND US

SECURITY CODE

ISSUER LEVERAGE FACTOR

AUM (HKD MN)

TRADING VOLUME (SHARE)

TOTAL EXPENSE

RATIO

MANAGEMENT FEES

CLOSING PRICE

7210 Enhanced Investment

Products

2x 78.61 221,000 1.88% 0.88% 18.80

Source: Bloomberg, as of 7 February 2018.

7210.HK: XIE Shares Chimerica FTSE N Share Daily 2x Leveraged Product was a 2x

leveraged product listed in Hong Kong, tracking 2x of its benchmark index. The benchmark

index of 7210.HK was CHIMERICA: FTSE China N Shares All Cap Capped Net Tax Index.

The index consisted of companies incorporated outside the PRC, traded on the NYSE, the

NASDAQ exchange, or the NYSE MKT, and controlled by Mainland Chinese entities,

companies or individuals, with a majority of its revenue or assets derived from PRC.

Top 10 Holdings of CHIMERICA: FTSE China N Shares All Cap Capped Net Tax Index

INSTRUMENT % WEIGHT

JD.COM INC-ADR 10.94

CTRIP.COM INTERNATIONAL 10.09

ALIBABA GROUP HOLDING 9.51

NETEASE INC-ADR 9.00

BAIDU INC - SPON ADR 8.89

NEW ORIENTAL EDUCATIO-SP 7.85

TAL EDUCATION GROUP- ADR 6.07

SINA CORP 4.47

58.COM INC-ADR 4.12

VIPSHOP HOLDINGS LTD 3.68

Source: Bloomberg, as of 7 February 2018.

Additional market data of 7210.HK are given in the worksheet “7210.HK” of the accompanying

case spreadsheet “L&I Products in HK_Data.xlsx.”

There were also other leveraged and traditional ETFs in US tracking Chinese internet stocks.

CWEB: Direxion Daily CSI China Internet Index Bull 2x Shares was a leveraged ETF

incorporated in the US. It tracked 2x the return of CSI Overseas China Internet Index. KWEB:

KraneShares CSI China Internet Fund was an ETF incorporated in the US tracking the return

of CSI Overseas China Internet Index.

SECURITY CODE

ISSUER LEVERAGE FACTOR

AUM (USD MN)

TRADING VOLUME(SHARE)

TOTAL EXPENSE

RATIO

MANAGEMENT FEES

CLOSING PRICE

CWEB Rafferty Asset

Management

2x 121.31 163,000 0.95% 0.75% 52.80

KWEB Krane Funds 1x 1493.94 599,900 0.72% 0.68% 59.96

Source: Bloomberg, as of 7 February 2018.

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Top 10 Holdings of CWEB:

INSTRUMENT % WEIGHT

US DOLLAR 14.87

TENCENT HOLDINGS LTD 6.62

ALIBABA GROUP HOLDING-S 5.98

BAIDU INC - SPON ADR 4.56

VIPSHOP HOLDINGS LTD - A 4.26

JD.COM INC-ADR 4.13

NETEASE INC-ADR 3.79

AUTOHOME INC-ADR 2.85

YY INC-ADR 2.78

WEIBO CORP-SPON ADR 2.75

Source: Bloomberg, as of 7 February 2018.

Top 10 Holdings of KWEB:

INSTRUMENT % WEIGHT

TENCENT HOLDINGS LTD 10.13 ALIBABA GROUP HOLDING-S 9.15

BAIDU INC - SPON ADR 6.97 VIPSHOP HOLDINGS LTD - A 6.52

JD.COM INC-ADR 6.31 NETEASE INC-ADR 5.79

AUTOHOME INC-ADR 4.36 YY INC-ADR 4.25

WEIBO CORP-SPON ADR 4.20 MOMO INC-SPON ADR 4.03

Source: Bloomberg, as of 7 February 2018.

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EXHIBIT 5. ETFS TRACKING INDIAN STOCK INDICES OFFERED IN HONG KONG AND US

SECURITY CODE

ISSUER LEVERAGE FACTOR

AUM (HKD MN)

TRADING VOLUME (SHARE)

TOTAL EXPENSE

RATIO

MANAGEMENT FEES

CLOSING PRICE

7335 CSOP Asset Management

-1x 11.67 0 1.85% 0.99% 12.68

Source: Bloomberg, as of 7 February 2018.

7335.HK: CSOP Nifty 50 Daily –1x Inverse Product was an exchange-traded fund incorporated

in Hong Kong. It was a future-based product that invested directly in futures on the Nifty 50

Index listed on the Singapore Exchange so as to provide investment results that, before fees and

expenses, closely corresponded to the inverse –1x of the daily performance of Nifty 50 Index.

The Nifty 50 Index was computed using a float-adjusted, market capitalization weighted

methodology. It tracked the behavior of a portfolio of blue-chip companies, the largest and most

liquid Indian securities domiciled in India and listed on NSE (National Stock Exchange of India

Ltd.).

Top 10 Holdings of 7335.HK:

Instrument % Weight

HDFCBANK 9.64

RELIANCE 7.79

HDFC 7.34

ITC 5.44

INFY 5.40

ICICIBANK 5.33

LT 4.10

TCS 3.64

KOTAKBANK 3.47

MARUTI 2.97

Source: National Stock Exchange of India, as of 31 January 2018.

Additional market data of 7335.HK are given in the worksheet “7335.HK” of the accompanying

case spreadsheet “L&I ETFs in HK_Data.xlsx.”

Leveraged or Traditional ETFs Listed in US tracking Indian Market

SYMBOL ETF NAME TOTAL ASSETS (USD

MN)

YTD RETURN

TRADING VOLUME (SHARE)

PREVIOUS CLOSING

PRICE

INDA iShares MSCI India ETF 5457.46 -3.13% 5,645,800 34.94

EPI WisdomTree India Earnings Fund

1739.85 -2.8% 3,006,300 27.06

INDY iShares India 50 ETF 1198.5 -1.35% 187,800 36.62

SMIN iShares MSCIIndia Small-Cap ETF

339.19 -7.27% 83,700 48.75

PIN Invesco India ETF 292.9 -2.01% 123,700 25.87

SCIF VanEck Vectors India Small-Cap Index ETF

347.05 -9.57% 60,900 61.33

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INCO Columbia India Consumer ETF

148.46 -6.79% 45,600 46.25

INDL Direxion Daily India Bull 3x Shares

95.21 -10.79% 133,500 91.08

INXX Columbia India Infrastructure Index

Fund

53.51 -6.71% 68,300 14.80

SCIN Columbia India Small Cap Fund

32.25 -8.75% 9,400 21.38

NFTY First Trust India NIFTY50 Equal

Weight ETF

3.35 8.69% - 33.31

Source: HKEx and Bloomberg, as of 7 February 2018.

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APPENDIX 1. DAILY INVESTMENT OBJECTIVES

For a holding period longer than one day, the performance of L&I ETFs could deviate from the

multiple or inverse of the underlying index’s cumulative return, due to the compounding effects

of daily returns. 75

1. Taking the example of a 2x leveraged product, we assumed that:

• If the investor held the leveraged product for two trading days;

• On the first trading day, the underlying index moved up by 3%;

• On the second trading day, the underlying index moved up by 3%;

At the end of the second trading day, the underlying index would move up by:

(1+3%) ⋅ (1+3%) − 1 = 6.09%.

At the end of the second trading day, the 2x leveraged product would move up by:

(1+6%) ⋅ (1+6%) – 1 = 12.36%.

We noticed that:

12.36% ≠ 6.09% ⋅ 2.

i.e., the performance of the leveraged product was not equal to the multiple (2x) of the

underlying index’s cumulative return when the leveraged product was held for more than one

trading day.

We took a look at more examples when the underlying index moved down or fluctuates during

a two-day period.

2. For a 2x leveraged product, assumed that:

• If the investor held the product for two trading days;

• On the first trading day, the underlying index moved down by 5%;

• On the second trading day, the underlying index moved down by 5%;

At the end of the second trading day, the underlying index would move by:

(1-5%) ⋅ (1-5%) − 1 = -9.75%.

At the end of the second trading day, the 2x leveraged product would move by:

(1-10%) ⋅ (1-10%) – 1 = -19%.

We noticed that:

-19% ≠ -9.75% ⋅ 2.

3. For a 2x leveraged product, assumed that:

• If the investor held the product for two trading days;

• On the first trading day, the underlying index moved up by 10%;

• On the second trading day, the underlying index dropped back to the original level as

the beginning of the first trading day.

75 “Structured Products,” 2018.

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At the end of the second trading day, the underlying index stayed flat. The movement of the

index during the two-day period was:

(1+10%) ⋅ (1- 1

11 ) − 1 = 0.

At the end of the second trading day, the 2x leveraged product would move by:

(1+20%) ⋅ (1- 2

11 ) − 1 = -1.818%.

In this case, if an investor of the 2x leverage product held the product for two days, he would

suffer a loss despite that the underlying index was flat.

4. For a 2x leveraged product, assumed that:

• If the investor held the product for two trading days;

• On the first trading day, the underlying index moved from $100 to $110.

• On the second trading day, the underlying index dropped from $110 to $100.5.

The underlying index moved up by 0.5% during the two-day period.

At the end of the second trading day, the underlying index stayed flat. The movement of the

index during the two-day period was:

(1+10%) ⋅ (1- 9.5

110 ) − 1 = 0.5%.

At the end of the second trading day, the 2x leveraged product would move by:

(1+20%) ⋅ (1- 19

110 ) − 1 = -0.727%.

In this case, if an investor of the 2x leverage product held the product for two days, he would

suffer a loss even if the underlying index moved up.

From the examples above, we understood that the leveraged ETFs only sought to replicate the

multiple of the underlying index's daily return. For a holding period longer than one day, the

performance of the leveraged ETFs deviated from the multiple of the underlying index's return

due to compounding effects. It was possible that the leveraged ETFs and the underlying index

moved toward opposite directions when being held for longer than one day!

Inverse ETFs had similar issues due to compounding effects of the daily return. We took the

following examples:

5. For a -1x inverse product, assumed that:

• If the investor held the product for two trading days;

• On the first trading day, the underlying index moved from $100 to $110.

• On the second trading day, the underlying index dropped back from $110 to $100.

At the end of the second trading day, the underlying index stayed flat. The movement of the

index during the two-day period was:

(1+10%) ⋅ (1- 1

11 ) − 1 = 0.

At the end of the second trading day, the -1x inverse product would move by:

(1-10%) ⋅ (1+ 1

11 ) − 1 = -1.818%.

In this case, if an investor of the -1x inverse product held the product for two days, he would

suffer a loss despite that the underlying index was flat.

We therefore understood that the investment objective of L&I ETFs was daily, i.e., they were

designed for daily investment results and were only suitable for investors who actively

monitored their holdings on a daily basis and could respond when market conditions changed.

L&I ETFs were not suitable for long-term investing.

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APPENDIX 2. DAILY REBALANCING

1. Maintaining the Leverage Factor

L&I ETFs needed to rebalance their portfolio on a daily basis so that the leverage factor was

maintained at its target level. To illustrate daily rebalancing, we took a look at the following

examples 7677:

• Daily rebalancing of a 2x leveraged product in a down market

• At the beginning of a trading day, assume that a 2x leveraged product’s net asset value (NAV) (i.e. index level) was $100 and its exposure to the underlying index was $200 (2x index exposure).

• During the trading day, the underlying index level dropped by 1%.

• At the end of the trading day, the 2x leveraged product’s NAV dropped to $98 ($100 - $100 ⋅ 1% ⋅ 2 = $98) and its exposure to the underlying index also dropped to $198 ($200- $100 ⋅ 1% ⋅ 2=$198).

• If daily rebalancing did not take place, the leverage factor became

$198 $98

=2.02.

So it effectively turned to a 2.02x leveraged product instead of a 2x one without

daily rebalancing.

• At the end of the trading day, the 2x leveraged product rebalanced its portfolio by reducing its underlying index exposure by $2 to $196, so that the leverage

factor was restored to 2x   

  

$196 $98

=2 .

• Daily rebalancing of a 2x leveraged product in an up market

• At the beginning of a trading day, assume that a 2x leveraged product’s NAV (i.e. index level) was $100 and its exposure to the underlying index was $200 (2x index exposure).

• During the trading day, the underlying index rose by 1%.

• At the end of the trading day, the 2x leveraged product’s NAV increased to $102 ($100 + $100 ⋅ 1% ⋅ 2 = $102) and its exposure to the underlying index also rose to $202 ($200+ $100 ⋅ 1% ⋅ 2=$202).

• If daily rebalancing did not take place, the leverage factor became

$202 $102

=1.98.

• At the end of the trading day, the 2x leveraged product rebalanced its portfolio by acquiring additional underlying index exposure of $2 to $204, so that the

leverage factor was restored to 2x   

  

$204 $102

=2 .

76 “Structured Products,” 2018. 77 The Chin Family, “Know more about daily rebalancing,” 2018.

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Inverse ETFs required daily rebalancing to maintain the leverage factor as well.

• Daily rebalancing of a -1x inverse product in a down market

• At the beginning of a trading day, assume that an -1x inverse product’s NAV (i.e. index level) was $100 and its short exposure to the underlying index level was $100 (-1x index exposure).

• During the trading day, the underlying index dropped by 1%.

• At the end of the trading day, the -1x inverse product’s NAV increased to $101 ($100 + $100 ⋅ 1% = $101) while its short exposure to the underlying index dropped to $99 (-$100 + $100 ⋅ 1% = -$99).

• If daily rebalancing did not take place, the leverage factor became

− $99

$101 =−0.98

instead of -1x.

• At the end of the trading day, the -1x inverse product rebalanced its portfolio by increasing its short exposure of underlying index by $2 to $101, the leverage

factor was restored to -1x   

  

− $101 $101

=1 .

• Daily rebalancing of a -1x inverse product in an up market

• At the beginning of a trading day, assume that an -1x inverse product’s NAV (i.e. index level) was $100 and its short exposure to the underlying index was $100 (-1x index exposure).

• During the trading day, the underlying index rose by 1%.

• At the end of the trading day, the -1x inverse product’s NAV dropped to $99 ($100 - $100 ⋅ 1% = $101) while its short exposure to the underlying index rose to $101 (-$100 - $100 ⋅ 1%= -$101).

• If daily rebalancing did not take place, the leverage factor became

− $101

$99 = −1.02

instead of -1x.

•

 At the end of the trading day, the -1x inverse product rebalanced its portfolio by reducing its short exposure of underlying index by $2 to $99, so that the

leverage factor was restored to -1x (− $99

$99 = -1) .

As a result of rebalancing, an L&I Product was only expected to track the multiple/opposite

return of the underlying index for the rebalancing interval—one trading day. It might not track

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the multiple/opposite return of the underlying index when it was held for less than a full trading

day or overnight78.

2. Trade L&I ETFs During a Trading Day

L&I ETFs sought to achieve their stated investment objectives on a daily basis. We understood

from the previous examples about maintaining the leverage factor that the leverage factor of

L&I ETFs during a trading day changed as the market moved. If you bought or sold an L&I

Product during a trading day, you might not be able to get the multiple or opposite of the return

of the underlying index until the next rebalancing.79

• Trading a 2x leveraged product when the market has gone up during a trading day

• At the start of a trading day, assuming that the leveraged product’s NAV was $100, so its exposure to the underlying index was $200.

• At 2pm, the underlying index rose by 4%. The leveraged product made a gain of 8%, and its NAV and exposure to the underlying index also rose to $108 and $208 respectively.

• The leverage factor became

$208 $108

=1.93.

• As such, if you traded this leveraged product at 2pm, your expected return would be equal to 1.93x the underlying index’s return instead of 2x until the next rebalancing.

• Trading a 2x leveraged product when the market has gone down during a trading day

• At the start of a trading day, assuming that the leveraged product’s NAV was $100, so its exposure to the underlying index was $200.

• At 2pm, the underlying index dropped by 4%. The leveraged product made a loss of 8%, and its NAV and exposure to the underlying index also dropped to $92 and $192 respectively.

• The leverage factor became

$192

$92 = 2.09.

• As such, if you traded this leveraged product at 2pm, your expected return would be equal to 2.09x the underlying index’s return instead of 2x until the next rebalancing.

• Trading a -1x inverse product when the market has gone up during a trading day

• At the start of a trading day, assuming that the inverse product’s NAV was $100, so its short exposure to the underlying index was also $100.

78 “Structured Products,” 2018. 79 The Chin Family, “Trade L&I Products during a trading day,” 2018.

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• At 2pm, the underlying index rose by 4%. The inverse product made a loss of 4%, and its NAV and short exposure to the underlying index would be $96 and $104 respectively.

• The leverage factor became

− $104 $96

=−1.08.

• As such, if you traded this inverse product at 2pm, your expected return would be equal to -1.08x the underlying index’s return instead of -1x until the next rebalancing.

• Trading a -1x inverse product when the market has gone down during a trading day

• At the start of a trading day, assuming that the inverse product’s NAV was $100, so its short exposure to the underlying index was also $100.

• At 2pm, the underlying index dropped by 4%. The inverse product made a gain of 4%, and its NAV and short exposure to the underlying index would be $104 and $96 respectively.

• The leverage factor became

- $96

$104 = −0.92

• As such, if you traded this inverse product at 2pm, your expected return would be equal to -0.92x the underlying index’s return instead of -1x until the next rebalancing.

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APPENDIX 3. RISK FACTORS OF L&I ETFS

 Investment risk: There was no guarantee of repaying the principal amount.

 Volatility risk: Prices of L&I ETFs tended to be more volatile than conventional ETFs because

of leveraging and rebalancing activities.

 Long-term holding risk: L&I ETFs were not intended for holding longer than one trading day.

 Risk of rebalancing activities: There was no guarantee that L&I ETFs could rebalance their

portfolios on a daily basis to achieve their investment goals.80 Market disruption, regulatory

restrictions or extreme market volatility might adversely affect rebalancing activities.

 Liquidity risk: Rebalancing typically took place near the end of a trading day (shortly before

the close of the underlying market) to minimize tracking difference. The short interval of

rebalancing might result in more exposure of L&I ETFs to market volatility and higher liquidity

risk.81

 Intraday investment risk: Leverage factor of L&I ETFs might change during a trading day

when the market moves but rebalancing would not happen until the end of the day.

 Portfolio turnover risk: Daily rebalancing caused a higher levels of portfolio transaction when

compared to conventional ETFs, thus increased brokerage and other transaction costs.

 Correlation risk: Fees, expenses, transactions cost as well as the costs incurred by using

financial derivatives might reduce the correlation between the performance of L&I ETFs and

the leveraged or inverse performance of the underlying index on a daily basis.

 Termination risk: L&I ETFs must be terminated when all the market makers resigned.

Termination of the L&I Product should take place at about the same time when the resignation

of the last market maker became effective.

 Leverage risk (for leveraged ETFs only): The use of leverage magnified both gains and losses

of leveraged ETFs resulting from changes in the underlying index or, where the underlying

index was denominated in a currency other than the leveraged product's base currency, from

fluctuations in exchange rates.

 Unconventional return pattern (for inverse ETFs only): Inverse ETFs aimed to deliver the

opposite of the daily return of the underlying index. If the value of the underlying increased for

extended periods, or where the exchange rate of the underlying index denominated in a currency

other than the inverse product's base currency rose for extended periods, it was possible that

inverse ETFs lose most or all of their value.

 Inverse ETFs vs short selling (for inverse ETFs only): Investing in inverse ETFs was different

from taking a short position. Due to rebalancing, the performance of inverse ETFs might deviate

from a short position particularly in a volatile market with frequent directional swings.82, 83

 Credit and default risks (for swap-based L&I ETFs): Investing in swap-based L&I ETFs were

exposed to counterparty risk and default risk of the swap counterparty and might suffer great

losses if a swap counterparty failed to fulfill its obligations.

 Futures contract risks (for futures-based L&I ETFs): Investing in futures-based L&I ETFs

involved specific risks including high volatility, leverage, rollover and margin risks. The

80 “Structured Products,” 2018. 81 Ibid. 82 Ibid.. 83 “Client Agreement Terms and Conditions,” 2018, http://www.uobkayhian.com.hk/en/help/forms/client-agreement-cash-or-

margin-account-en.pdf, accessed on 4 October 2018.

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investors were also exposed to the risk that the performance of the futures contracts might

deviate from the L&I ETFs’ investment objective.84

Source: The Chin Family, “Benefits and Risk”, 2018,

https://www.thechinfamily.hk/web/en/financial-products/investment/leveraged-and-inverse-

products/benefits-risk.html (accessed on 25 April 2018).

HSBC, “EXPLANATION OF RISKS FOR LISTED DERIVATIVES (INCLUDING LEVERAGED

AND INVERSE PRODUCTS) IN HONG KONG AND OVERSEAS MARKETS (For Personal

Customer)”, 2017, https://www2.ebanking.hsbc.com.hk/1/PA_esf-ca-app-

content/content/hongkong/pdf/investments/risks_for_listed_derivatives.pdf (accessed on 24 April

2018).

“Structured Products”, 2018, http://www.hantec.hk/sites/default/files/structured_products.pdf

(access on 4 October 2018).

“Client Agreement Terms and Conditions”, 2018,

http://www.uobkayhian.com.hk/en/help/forms/client-agreement-cash-or-margin-account-en.pdf

(accessed on 4 October 2018).

Prepared by author.

84 “Structured Products,” 2018.

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