Hong Kong Approves Leveraged ETFs While Warning Traders of Risks

  • Margin financing is discouraged for investors in the funds
  • Leveraged ETFs face tougher rules in U.S. but remain popular

Hong Kong has authorized leveraged and inverse exchange-traded funds in the city, while adding a note of caution to investors.

The Securities and Futures Commission on Friday published a circular for the ETFs, setting requirements from product naming to market making arrangements. The regulator also introduced conditions for firms who plan to offer the funds to “protect the interests of the investing public of Hong Kong and to maintain the integrity” of the city’s market, it said in the posting on its website.

Leveraged ETFs use derivatives to increase the size of gains or losses on an underlying index, while inverse ETFs give traders a way to profit from falling markets. The products, popular in countries from the U.S. to Japan, have come under scrutiny for exposing individual investors to the potential for outsized swings that they may not fully understand.

Margin financing for leveraged and inverse ETFs will be allowed, depending on the risk management policy of an individual exchange participant, Hong Kong Exchanges and Clearing Ltd. said in a separate circular on Friday. However, exchange participants “are advised not to provide margin financing to investors for trading” for these types of ETFs, the exchange said. Margin financing, which allows investors to hold a product by providing collateral worth a fraction of the asset value, can amplify potential returns or losses.

Investor Warnings

The funds have attracted criticism in the U.S., where BlackRock Inc.’s Laurence Fink and Wall Street’s brokerage regulator, the Financial Industry Regulatory Authority, have warned about their dangers. About 4 percent of funds in the U.S. have exposure that exceeds 150 percent of net assets, according to December study by the Securities and Exchange Commission.

Fink, whose firm is the world’s largest asset manager, said in May 2014 that leveraged ETFs have the potential to “blow up” the industry and that he couldn’t understand why the SEC approved their sale in the first place. BlackRock owns the iShares family of exchange-traded products. Finra, which polices the sales practices of brokers, also came down on ETFs in June 2009, when it said they “typically are unsuitable for retail investors who plan to hold them for longer than one trading session.”

The SEC issued a plan in December that could cripple many leveraged and inverse ETFs by capping the leverage they can derive from derivatives at 150 percent of their net assets. The U.S. agency’s plans would also force them to hold a lot more cash to cover potential losses.

Not everyone is so wary. Earlier this year, the Next Funds Nikkei 225 Leveraged Index ETF was the world’s most popular equity ETF, taking in 177.4 billion yen ($1.5 billion) in the first weeks of the year. The ETF uses futures to produce twice the Nikkei 225 Stock Average’s return, and is down 23 percent in 2016.

Leveraged and inverse funds have become increasingly popular in overseas markets, particularly in Asia, and there may be demand for these products in Hong Kong, the SFC said in its statement.

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