Important Information About Funds
Investing in Funds
Funds are typically referred to as collective investment schemes, which may take many different forms (see below some examples) and can use different investment strategies as well as invest in many different types of underlying investment products. Funds are NOT equivalent to time deposits.
An investment in funds will therefore expose an investor to different risks depending on the form of the fund, its investment manager and its investment strategy. For example, Investors own shares/ units of the fund, not the individual securities.
Investors will not have control over the assets of the scheme but the assets will instead be managed by a manager, in exchange for a fee. Income and profits (or losses) are pooled before being distributed to investors.
In the worst case scenario, the value of the units/ shares may be worth substantially less than the original amount you have invested.
What are the different types of Funds?
Mutual Funds
“Mutual funds” are generally funds where the investors pool their funds together and the funds are regulated and professionally managed. They are generally classified by their principal investments: money market funds, bond or fixed income funds, stock or equity funds and hybrid funds. Funds may also be categorised as index (or passively managed) or actively managed or based on other investment objective such as growth or income or focus on specific markets
Regulated Collective Investment Schemes
Regulated collective investment schemes are authorised or regulated by regulators. There is a wide range of regulated collective investment schemes and these include, for example, unit trusts, mutual funds and exchange traded funds. Regulated collective investment schemes are subject to stricter investment and borrowing limits which may reduce a fund’s ability to take risks.
Unregulated Collective Investment Schemes
Unregulated funds are not authorised or regulated by any regulator. They are therefore subject to fewer restrictions than regulated collective investment schemes and could carry additional risks.
Closed-Ended Funds
A closed-end fund is a collective investment model based on issuing a fixed number of shares which are not redeemable from the fund. Unlike open-end funds, new shares in a closed-end fund are not created by managers to meet demand from investors. Instead, the shares are purchased and sold usually only in the market. The price per share is determined by the market and is usually different from the underlying value or net asset value (NAV) per share of the investments held by the fund. The price is said to be at a discount or premium to the NAV when it is below or above the NAV, respectively.
Alternative funds
These are typically unregulated funds and use complex investment strategies or illiquid investments that will have higher risks. Examples include hedge funds, private equity funds and real estate funds.
What are the risks associated with the investment in funds?
Generally, each fund bears the risks related to its investment strategy and underlying Investment products as well as more specific risks related to the fund features.
Set out below is a list of key risks associated with investing in certain types of funds. You should also specifically to the fund prospectus and offering materials to understand the specific risks associated with the risks:
Capital growth risk– Some funds may have fees and/or dividends paid out of capital. As a result, the capital that the fund has available for investment in the future and capital growth may be reduced.
Capital tie up and receipt of income– Each unregulated fund will have different rules in respect of the sale of units in the scheme and whether income will be paid. This could mean that an investor’s capital is tied up in the scheme for substantial periods of time and/or that no income is received on the investment.
Changes in investment policy– The manager of a fund typically has the authority to alter its investment policy within certain parameters (set out in its constitutional document) by amending the fund’s prospectus. From an investor’s perspective, this could represent a significant change in the nature and risk profile of the fund from the one in which was originally invested in.
Collateralised and/or securitised products (such as asset backed securities, mortgage backed securities and asset backed commercial papers)– If a fund invests in collateralised and/or securitised product, such as asset backed securities, these may be highly illiquid and prone to substantial price volatility. These instruments may be subject to greater credit, liquidity and interest rate risk compared to other debt securities. They are often exposed to extension and prepayment risks and risks that the payment obligations relating to the underlying assets are not met, which may adversely impact the returns of the securities.
Not protected by Investor Compensation Fund– Many compensation schemes do not cover unregulated funds. Transactions in unregulated funds will not be covered by the Investor Compensation Fund in Hong Kong and accordingly, investors will not be covered by the Investor Compensation Fund in respect of any loss sustained by reason of a default by any SFC licensed or registered person.
Credit / counterparty risk– A fund is exposed to the credit/default risk of issuers of the debt securities that the fund may invest in. A fund may effect many of its transactions in the over-the-counter or inter-dealer markets. Because the participants in these markets are typically not subject to regulatory oversight, the fund may be exposed to some risk that a counterparty will not timely settle a transaction, thus causing the fund potentially to suffer a loss. The ability of the fund to transact business with any one or any number of counterparties, the lack of any independent evaluation of such counterparties' financial capabilities and the absence of a regulated market to facilitate settlement may increase the potential for losses by the fund.
Currency risk– Fund performance will be impacted by whether the underlying investment currencies are hedged back to the main fund strategy currency as well as whether the invested share class is hedged. A fund may or may not seek to hedge all or any portion of its foreign currency exposure. To the extent unhedged, the value of the fund's assets will fluctuate with the fund’s main currency exchange rates as well as the price changes of the fund's investments in the various local markets and currencies. Further, the fund could realise a net loss on an investment, even if there were a gain on the underlying investment before currency losses were taken into account. There can be no assurance that any hedging strategies used will be effective, and such techniques entail costs and additional risks.
Early termination risk– A fund may be subject to the risk of early termination under certain circumstances as specified in the fund prospectus. In the event of early termination, any unamortised costs would be written off and the amount you receive may be less than your invested principal.
Exposure to market volatility– Whilst there may be a liquid market in the units in some funds, this means that the units are subject to market sentiment which may not value the units in the same way as the underlying investments.
Exposure to underlying assets– A fund will be exposed to the movement in price of the assets underlying the fund. Should the value of the underlying assets depreciate, it is very likely that the value of a unit in the fund will also depreciate.
General investment risk– All securities investments risk the loss of capital. The nature of the securities to be purchased and traded by the fund and the investment techniques and strategies to be employed by the fund’s managers may increase this risk. Investors could lose all or a substantial amount of their investment.
Legal, regulatory and tax risk– Developments from the legal, regulatory and tax perspective, both locally and internationally, could result in a fund or investors of a fund being subject to additional restrictions or requirements and this could also have a significant effect on the nature and performance of the fund.
Limited diversification of investments– Some funds may have very narrow investment parameters including but not limited to exposure to a single asset class, single country or single sector. Such narrow investment parameters expose the scheme to substantial unhedged losses in the event of a fall in the general price of the relevant investment.
Liquidity and redemption risk– A fund’s liquidity may be impacted by the underlying securities liquidity as well as by the level of redemption requests. Some funds may invest in securities with varying levels of liquidity potentially resulting in exposure to illiquidity risk. For example, units in unregulated funds may be hard to dispose of as there may not be a ready market for their purchase. Under certain extraordinary circumstances, the manager of a fund may elect to temporarily suspend the redemption of units and only redeem units at a later time at the then-applicable price. This price may be lower than the price prior to the suspension of redemption. As well, some funds may apply gating at the time of redemption and / or require a certain notification period prior to accepting a redemption request.
Management and key personnel risk– The performance of a fund is largely dependent on the skill and decisions made by its manager and key personnel. As such, the loss of any such individuals could have a material adverse effect on the performance of the fund.
Pricing adjustment / anti-dilution measures– A fund manager may apply anti-dilution measures in order to minimise the dilution effect of a fund’s NAV for the purpose of safeguarding the interest of those investors remaining in the fund. Anti-dilution levy and swing pricing are common types of anti-dilution measures applied by funds against material or frequent investors dealing, especially when this involves the purchase and/or sale of the underlying investments in a fund portfolio, that would incur trading costs and related expenses including transaction charges, brokerage fees, taxes and bid/offer spreads. The aggregate costs arising from such purchase and/or sale of the underlying investments in a fund portfolio would be charged to the fund and therefore would dilute its NAV. As such, individual subscribing/redeeming investors may be affected by the adjusted NAV.
Securities lending risk– A fund may engage in securities lending arrangements in order to enhance their returns. This entails lending securities from the fund portfolio to counterparties for a period of time in exchange for the deposit of collateral that the fund may invest with the objective of earning additional returns. The downside to this is that such arrangements would expose the investor to additional credit risk of the counterparties to the securities lending contracts. In the event that a counterparty defaults on its obligations and/or the value of the collateral deposited falls below the value of the securities lent to such counterparty, this will negatively impact the NAV of the fund.
Use of leverage– Some funds may use leverage/borrow money in order to increase the level of funds for investing. This could reduce (or completely eliminate) the funds available for distribution to investors.
Use of derivatives– Some funds may utilise instruments such as warrants, futures, options and forward contracts to enhance potential investment returns. While this can have the desired effect of enhancing the fund’s performance, it can also have a negative effect if the manager’s prediction regarding the direction of movement of the securities or money markets proves to be incorrect.
Valuation risk– Valuation of a fund’s investments could involve uncertainties and judgmental determinations. If such valuation turns out to be incorrect, this could affect the NAV calculation of the fund.
Short selling risk
Selling securities short involves the selling of borrowed securities with the expectation that the securities can be repurchased for return to the lender at a price lower than the initial sale price. Short selling risk arises for the fund because there is the possibility that the price of the borrowed securities could increase above the initial short sale price, leading to losses for the fund. Short selling is subject to the theoretically unlimited risk of loss because there is no limit on how much the price of a borrowed security may appreciate. Short selling has the effect of leveraging the investment return of the fund and carries the risks of magnifying the impact of negative returns and increased margin calls. Additionally, there is a risk that the security lender may request the return of the security, giving rise to the possibility that positions may have to be closed at a loss and not at a time of the fund’s choosing.
Interest rate risk
Changes in official interest rates can directly and indirectly impact (positively or negatively) on investment return. Interest rates have a direct impact on the cost of the fund’s borrowing activities. An increase in interest rates will generally lead to an increase in the fund’s borrowing costs, which will reduce the returns received by investors in the fund as those costs are borne by the fund. In addition, where borrowing costs are high, the fund may use less leverage than would otherwise be the case, which could reduce potential investment returns. Generally, an increase in interest rates also has a contradictory effect on the state of the economy and the valuation of securities. For example, rising interest rates can have a negative impact on an entity’s value as increased borrowing costs may cause earnings to decline. As a result, the entity’s share price may fall.
