It is increasingly common for pension monies under the Mandatory Provident Funds (MPF) regime to be invested in index strategies. The Mandatory Provident Fund Authority (MPFA) continues to encourage MPF providers to utilise index strategies, recognising their potential to provide diversified market exposure at comparatively low cost.
For index fund (or exchange traded fund (ETF)) providers, obtaining approval for an index tracking collective investment scheme (ITCIS) can be a relatively simple route to access MPF funds without having to establish or operate their own MPF schemes or approved pooled investment funds (APIF). While the MPFA imposes additional requirements (as discussed below), the ITCIS can continue to operate largely under its existing investment policies and restrictions.
An ITCIS is defined under section 1(1) of Schedule 1 to the Mandatory Provident Fund Schemes (General) Regulation (Regulation) as a collective investment scheme which has the sole investment objective of tracking a particular market index.
To be a permissible investment for MPF funds, an ITCIS must be approved by the MPFA.
This article provides an overview of the key requirements and approval process for ITCIS, and practical tips for potential applicants.
Key Requirements
The critical starting point is that there are two alternative routes by which an ITCIS can qualify for MPF investment; the ITCIS is either: (i) authorised by the Securities and Futures Commission (SFC); or (ii) listed on a stock exchange approved by the MPFA.
An SFC-authorised ITCIS has an obvious regulatory advantage, having already passed through the SFC-authorisation process. The MPFA recognises that the MPFA’s criteria for approval of ITCIS are generally consistent with the SFC’s requirements applicable to authorisation of unlisted index funds and/or index-tracking ETFs. But this does not mean that MPFA approval is automatic.
The second route is particularly relevant to overseas ITCIS listed on MPFA-approved stock exchanges such as in Australia, Canada, China, Ireland, United Kingdom and United States of America. For an overseas listed ITCIS, this is potentially the more commercially feasible route as SFC authorisation is not necessary.
It is pertinent to note that, neither route, by itself, is sufficient. In both cases, the ITCIS must separately obtain MPFA approval. The MPFA conducts a separate suitability assessment, applying the criteria in Guidelines III.10, including:
(i) the fund’s sole investment objective is tracking a particular market index;
(ii) the fund should seek to track an index by adopting a full replication strategy or a representative sampling strategy;
(iii) the reference index must comprise securities which are appropriate for MPF investments;
(iv) the fund should not engage in borrowing of money, lending of securities or the use of derivatives in a way inconsistent with the objectives of the MPF system.
The suitability of a reference index is key in the MPFA’s assessment. Guidelines III.10 sets out the criteria for a reference index including it should –
- be broadly based;
- not have a significant portion of its constituent securities (i) for equity indices, listed on non-approved stock exchanges; and (ii) for bond indices, that do not meet the requirements of section 7(2) of Schedule 1 to the Regulation;
- have a clearly defined objective and/or the market it aims to represent should be clear;
- be investible; and
- be transparent and published in an appropriate manner.
The reference index provider is expected to possess the necessary expertise and technical resources to construct, maintain and review the methodology/rules of the index.
Additional criteria may apply depending on whether the ITCIS is SFC-authorised or listed on an approved stock exchange.
Approval Process
An applicant for approval of an ITCIS will usually be the fund manager, while overseas ITCIS is expected to have a local representative to liaise with MPF investors. Overseas managers with a Hong Kong affiliate will have an advantage in appointing such affiliate as the local representative, which can also take on marketing for the funds. Formal submission of applications for approval of an ITCIS should be made electronically via the MPFA’s eApplication Submission Platform (eAS). Applicants who do not have an eAS account will need to send an email to the MPFA to request the setting-up of an account. Sufficient time should be allowed for the account set-up process before the submission of the formal application.
The MPFA’s current performance pledge is to complete the approval of ITCIS within 4 weeks after receipt of all required information and documents.
Practical Tips
Pre-consultation with the MPFA is generally recommended, particularly for new applicants, and where an applicant intends to seek approval of a large number of ITCIS at the same time. Early engagement with the MPFA allows major issues to be identified and addressed at an early stage, thereby facilitating a smoother formal application process.
From recent experience, we have observed that an ITCIS will be required to demonstrate a “business case”, i.e. it can attract actual MPF investment, which will usually be a commitment from existing MPF schemes or APIF. As part of the approval process, the MPFA may also take into account factors such as the level of fees relative to comparable products and whether there are multiple ITCIS from the same fund manager offering similar investment strategies.
The ITCIS and the index it seeks to track will be reviewed, including the current constituents and the corresponding fund holdings, for compliance with the substantive requirements under Guidelines III.10. An index with a high exposure to a single constituent (i.e. exceeding 20%) will generally be regarded as too concentrated. An exception may apply where exceptional market conditions justify a weighting of up to 35% provided that each remaining constituent security does not exceed 20%. An index with only a small number of constituents may likewise be regarded as highly concentrated. It is therefore, important to conduct a “concentration” analysis based on the latest index constituents to ensure that the index is able to meet the MPFA’s requirements.
Other key issues include the extent of derivative usage and investment in stock lending and repurchase transactions. For example, an applicant should be ready to explain whether derivatives are used for hedging or investment purposes. It should not be assumed that because a technique is permitted under the SFC regime, it will automatically be accepted by the MPFA for approval of ITCIS.
Deacons has experience advising on applications for approval of ITCIS and related matters. Please reach out to our team for further information.
For further information, please contact:
Ming Chiu Li, Partner, Deacons
mingchiu.li@deacons.com
