China's Innovative Fund Products: ETFs And LOFs
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China's Innovative Fund Products: ETFs And LOFs

China's stock market has opened up to innovative investment products this year.

China's stock market has opened up to innovative investment products this year. The Shanghai Stock Exchange is now trading SSE50 Exchange-Traded Funds, the first ETFs in China, and the Shenzhen Stock Exchange has introduced listed open-ended funds, or LOFs. LOFs and ETFs sound similar to many investors but although they share similar creation, redemption and trading features, they have certain fundamental differences.

 

SSE50 Exchange-Traded Funds

An ETF is a listed security which tracks the performance of an established index or predetermined basket of securities. It combines some of the characteristics of an ordinary share with those of an investment fund. It is similar to an index-tracking mutual fund but it can be traded on the stock exchange like a listed company.

The SSE50 ETFs started trading on the Shanghai Stock Exchange in February 2005 and are the first local ETFs based solely on local Yuan-denominated shares, known as 'A' shares. They track the Shanghai 50 Index, which consists of mostly blue-chip 'A' shares listed on the Shanghai Stock Exchange. Prior to the SSE50 ETFs, China-related ETFs mostly attempted to track the shares of Chinese firms listed in Hong Kong or the U.S.

One important innovation in the SSE50 ETFs is their flexible creation process. ETFs are typically created by assembling a basket of shares that represent the index underlying the ETF. The SSE50 ETFs, however, can be created entirely from SSE50 index constituent stocks, or from a bespoke basket of single constituent stocks. This flexibility in the creation of the ETFs is believed to be unique. As such, the SSE50 ETFs provide a valuable risk management and diversification alternative for Chinese investors with concentrated stock positions.

The SSE50 ETFs permit T+0 trading between the creation or redemption of the ETF in the primary market and the ETF unit trading in the secondary market. This means investors can deliver shares to subscribe to an ETF from primary dealers and then sell the ETF unit in the secondary market, or, buy an ETF unit in the secondary market and then redeem it from primary dealers for the basket of shares to be sold in the stock market, all in the same trading day. This T+0 infrastructure facilitates arbitrage trades between the stock basket and the ETF unit, which prevents the SSE50 ETF trading price from deviating substantially from the net asset value of the underlying index portfolio. In comparison, exchange-traded closed-ended funds in China generally demonstrate significant discounts and--in some cases--premiums to their NAVs, as do the closed-ended funds in many foreign markets.

In addition to conventional ETF benefits such as low cost, trading flexibility and liquidity, the SSE50 ETFs also attract Chinese retail investors because they are a new way of trading the index. ETFs have a big advantage over index funds in capturing potential sudden market movements--which have not been uncommon in China's stock market history. This is because ETFs are a real-time purchase and gain market exposure instantly, whereas an index fund's value is generally calculated each day only after close.

 

Listed Open-Ended Funds

Before LOFs, closed-ended and open-ended funds in China had two separate issuing and custody systems and the two types of fund were traded in two separate markets. Closed-ended funds and ETFs are traded on the exchange, while open-ended funds are purchased or redeemed through fund companies, banks and securities companies. The first listed open-ended funds were launched on the Shenzhen Stock Exchange on December 20, 2004. Because they are open-ended funds that can also be listed and traded on the stock exchange, LOFs are expected to make mutual funds more attractive to investors by adding the liquidity of exchange trading.

Once approved by the Shenzhen Stock Exchange, the unit interests of a mutual fund can be issued through the trading system of the exchange and become listed as LOFs. LOF investors can either trade an LOF like a regular stock on the exchange, or redeem the LOF as they would a regular mutual fund. With the stock market trading near an historical low, Chinese retail investors are becoming more interested in principal-protected investments (DW Learning Curve, 3/7/2005), and they are putting substantial redemption pressure on mutual funds. Turning a mutual fund into an LOF gives investors another way of redeeming their investment, which potentially reduces the redemption pressure on the fund itself.

There are designated primary participating dealers at the exchange to ensure the liquidity of LOF trading. These dealers are similar to market-makers in developed markets, but with one major difference. Market-makers typically provide both bid and offer prices to manage the trading flow, but the primary participating dealers in China provide bid prices only. In addition, offering bid prices is not a continuous obligation. According to the exchange rules, the primary participating dealers are only obliged to provide a bid price when there is no "reasonable" bid price in the market for "a certain period of time".

LOFs offer similar arbitrage opportunities as the SSE50 ETFs. However, LOFs involve two trading systems and two depositary systems and the conversion between the LOF unit and the underlying mutual fund interests requires T+2 settlements to cross the two systems. In other words, it takes two days to purchase the mutual fund and then convert it into an LOF unit, or alternatively, to purchase the LOF unit and convert it into a mutual fund interest to be redeemed. As such, there is two-day risk in arbitraging a LOF and the underlying mutual fund.

 

Summary Of Differences Between LOFs And ETFs

SSE50 ETFs and LOFs are similar financial innovations, but with some key differences. Firstly, SSE50 ETFs are a new product for investors to trade the SSE50 index and LOFs offer investors an alternative way to redeem their mutual fund investments. Secondly, SSE50 ETFs are typically created from and redeemed as a basket of shares, but LOFs are created from and settle as cash. Thirdly, SSE50 ETFs track an index, so they are effectively a passive investment strategy, whereas LOFs have no constraints on investment strategies, so the mutual fund underlying a LOF could follow either an actively managed or a passively managed strategy. Finally, they have different potential arbitrage trading risks because their settlement and depositary systems differ.

 

This week's Learning Curve was written by Winston Ma, CFA, marketing specialist and products structurer in the equity capital and derivatives markets group at JP Morgan Securitiesin New York, and head of the corporate products steering committee of the Structured Products Association.

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