The lure of leveraged funds in China

Fund management companies in China are offering structured listed open-ended funds (Lofs) to high-net-worth retail investors, with some funds pushing leveraged multi-asset products traded both on exchanges and OTC simultaneously. The latest proposed structures include hedge fund and ETF underlyings. What are these structures and how are fund managers coping with their risks?

Regulators in the US and Europe have expressed concern about the suitability for retail investors of leveraged exchange-traded funds (ETFs) with features such as daily leverage resets, which can lead to a compounding of risk. But in China, retail investors are already actively trading hybrid leveraged ETF-like, asset-backed security products on exchange. These instruments appear to have attracted much less of a supervisory backlash, although new leverage rules are set for introduction.

‘Fenji jijin’, or ‘tranched-listed, open-ended funds’ (T-Lofs), represent the latest evolution of the listed open-ended fund (Lof) market on the Shenzhen Stock Exchange (SZSE). Lofs first started trading in 2001 ahead of other fund products such as ETFs and closed-end funds. To-date there are 22 T-Lofs listed on the exchange, with total asset under management amounting to some $6.86 billion (42.5 billion yuan), or 48.68 billion units. This compares with 67 Lofs listed on the exchange, with 11.48 billion units (the equivalent AUM value for Lofs is not available). Neither Lofs nor T-Lofs are traded on China’s biggest exchange, the Shanghai Stock Exchange.

The first T-Lof was launched in 2007 by UBS’s joint venture fund management firm, UBS SDIC. Each T-Lof comprises a parent fund, and two sub-funds, and interest in T-Lofs has reignited trading in the Lof market, which had previously received lukewarm interest from asset holders. Retail investors like T-Lofs as they can pick and choose the two listed sub-funds in any combination they desire to reflect their risk/return preference.

In a similar manner to the tranching of asset-backed securities, T-Lofs give investors the choice of a lower risk/return senior tranche and high risk/return junior tranche – with the latter using higher leverage to multiply the returns and losses from a fund’s net asset value rather than representing different credit risks.

Derivative-free

While leveraged ETFs also achieve the goal of amplifying return and loss through the use of derivatives, structurers of T-Lofs at major Chinese fund management companies have tended to steer clear of them. Instead, the leverage is achieved through splitting the parent fund into the two sub-funds, usually along splits of 6:4; 7:3 for bond funds, or 5:5 for equity funds.

“Lofs and ETFs are different in that in China usually you need to deliver or receive a basket of shares when you create and redeem ETF units; Lof investors have to buy in a cash amount. Also, for ETFs you can sell your units in the market in real-time; for Lofs there is a one-day delay before you can get hold of the shares,” says Zhang Shaohua, fund manager at SWS MU Fund Management, a joint venture between mainland Shenyin & Wanguo Securities and Mitsubishi UFJ Trust and Banking Corp in Shanghai.

The lack of derivatives, however, does not make T-Lofs any less complicated or risky for retail investors. In a typical T-Lof, the leverage is usually achieved through the less risky senior tranche effectively receiving a contracted return – for example, a 3% premium on top of the one-year benchmark lending rate set by the People’s Bank of China – to attract investor money away from bank deposits. Such contracted annual returns are paid by the leveraged junior tranche investors at the end of each investment period.

Meanwhile, the leveraged junior tranche receives the equity or fixed income benchmark return – or loss – multiplied by the leverage embedded in the product. These investors effectively buy that leverage by paying the contracted return to the senior tranche investors and none of this investment return is shared by the senior tranche holders.

But since the priority of payment usually goes first to the senior tranche to cover that contracted return, if at the end of the investment period the NAV of the parent fund drops to a level whereby it could not cover the senior tranche’s contracted return, the leveraged junior tranche’s NAV could drop to zero.

The senior tranche is not a safe, capital-guaranteed investment either.

“If the parent fund’s NAV drops so significantly that even after the leveraged junior tranche has shared its portion of loss and its NAV becomes zero, the senior tranche would face the risk of loss to its principal too,” says an analyst specialising in the T-Lof market at a Shanghai securities house.

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The lure of leveraged funds in China

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