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    Introduction of ETF
     
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  Introduction of ETF
What are ETFs?
Exchange Traded Funds are investment funds traded on stock exchange.

Listed and/or traded on HKEx and recognized by Securities and Futures Commission of Hong Kong (SFC), ETF is one of the investment products with fastest growth. ETF is a regulated open-end mutual fund. Most of the ETFs are passively-managed investment, aiming to purely track and replicate certain indices. Underlying investment in ETF can cover a series of stock markets (e.g developed and emerging markets) and a basket of assets (e.g bond, currency and commodity).
How are the ETF market conditions in Hong Kong at present?
The world's first ETF was first introduced on American Stocks Exchange in January 1993 and has been well-received by investors since debut. As of late third-quarter 2012, there were a total of 3,312 ETFs listed on 52 markets worldwide via 176 suppliers; assets managed by ETFs reached US$1,653 billion with rapid growth.

As for the number of listing, turnover of and asset size managed by ETF, HKEx is one of the leading markets in Asia. Turning into 2012, the development of Hong Kong ETFs has been accelerating with more diversified product types. In addition to ETFs denominated in Renminbi and linked to certain segments in Asia such as finance, information technology and industrial sector, there are ETF products tracking cumulative interest rate in foreign currency.
Compare the characteristics among ETF and other investment tools
An ETF has the features of stocks and traditional funds. Like stocks, an ETF can be traded via brokers and in most trading platforms during trading hours. An ETF can also track a basket of securities of underlying indices as an index fund does.

Comparison among ETFs, traditional funds and stocks
ETFTraditional fundStock
ManagementPassiveActivePersonal options
Risk DiversificationYesYesNo
Subscription FeeNoYes (around 5% or below)No
Total Fee Ratio/ Management FeeYes (around 0.15%-1.49%)Yes (around 1%-2.5%)No
Transaction ApproachContinuous daily tradingOnce a dayContinuous daily trading
Trading UnitBy unitWith minimum investment limitBy lot
YieldDividend (if any)Dividend (if any)Dividend (if any)
Clearance/SettlementT+2prepaymentT+2
Trading costGeneral brokerage fee and securities transaction fee (certain ETFs are exempted from stamp duty)Maximum 5%General brokerage fee and securities transaction fee
Market MakerYesNoNo
ListingYesNoYes
Provision of related derivativesYes (if permitted)NoYes (if permitted)
Short-sellingYes (if permitted)NoYes (if permitted)
What kinds of ETFs are traded on HKEx?
There are two types of ETFs traded on HKEx – physical ETF and synthetic ETF.

Physical ETFs (Traditional ETFs)
Physical ETFs replicate or represent the performance of benchmark through physical asset investment. Many physical ETFs directly buy all the assets needed to replicate the composition and weighting of their benchmark (e.g constituents of a stock index). However, some only buy a portion of the assets needed to replicate the benchmark or assets which have a high degree of correlation with the underlying benchmark but are not part of it. Some physical ETFs with underlying equity-based indices may also invest partially in futures and options contracts. Lending the shares they own is another strategy used by some physical ETFs. Investors should read the ETF prospectus carefully to ensure they understand how the fund operates.

Synthetic ETFs
Synthetic ETFs do not buy the assets in their benchmark. Instead, they typically invest in financial derivative instruments to replicate the benchmark’s performance. The ETFs are required to have collateral when investing in derivatives (details of the net and gross counterparty exposure and types and composition of the collateral are published on the ETF’s website). An ETF’s net risk exposure to any single counterparty (i.e net of the value of any collateral provided) cannot be more than 10% of its NAV. Investors should read the ETF prospectus carefully to ensure they understand how the fund operates.
How is a Hong Kong ETF named?
According to the Naming Convention of Stock Short Name for ETFs under HKEx:

Synthetic ETF : Short name is started with a 'X' mark in both English and Chinese, for example, X ISHARES A50.

Synthetic ETF traded in Renminbi: Short name is ended with an 'R' mark in both English and Chinese, for example, CSOP A50 ETF-R. (Note: The above naming convention for ETFs traded in Renminbi came into effect on 23 May 2012. The stock short name of ETFs traded in Renminbi listed before 23 May 2012 remains unchanged. )

Stock Code Allocation for ETFs
Ranges for ETFs (excluding ETF traded in Renminbi): 2800-2849 and 3000-3199
Ranges for ETFs traded in Renminbi: 82800-82948 and 83000-83199
ETF replication strategies
ETF replication strategies include full replication strategy, representative sampling strategy and synthetic replication strategy.

Full replication strategy
ETF fund managers hold positions in all the securities of the underlying index in proportion to their weighting in the index. This is a simple and transparent way that results in minimal deviation between the ETF performance and that of the underlying index. However, this strategy is subject to higher cost and transaction fee, particularly at the time when the constituents are of high volume and low liquidity.

Representative sampling strategy
ETF fund managers directly or indirectly hold position in representative securities samplings to replicate the characteristics of underlying index. Full replication strategy may not necessarily be feasible or involve high replication costs, as some indices may cover securities that are not easily bought by investors; certain securities may have insufficient liquidity and some constituents are of large volume.

Synthetic replication strategy
ETF fund managers make use of financial derivates, such as futures contracts or swap contracts, to track performance of underlying index. ETF suppliers sometimes can only adopt synthetic replication strategy as foreign investors are barred from certain stock market, such as China's A-share market and Indian stock market. This strategy is also adopted by ETF issuers in a bid to boost efficiency and reduce costs. ETFs using synthetic replication strategy are more exposed to counterparty risks as financial derivatives and swap contracts are issued by various issuers.

In terms of cost, the transaction cost of synthetic replication strategy is the lowest, followed by representative sampling strategy and full replication strategy.

In terms of risks associated with tracking index, synthetic replication strategy is least likely to be exposed to such risk, followed by full replication strategy and representative sampling strategy. Synthetic replication suffers counterparty risk.
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