Circular to management companies of SFC-authorized funds

This circular is directed to all management companies and the investment advisers which have been delegated the investment management function of SFC-authorized funds (collectively, “Managers”) regarding SFC-authorized funds (the “funds”) under their management. 

Managers’ fiduciary duties and ongoing disclosure obligations

In view of the European sovereign debt crisis and other new market risks that may have emerged, Managers are reminded of the following fundamental regulatory principles in managing SFC-authorized funds under the existing regime:

(i)            As part of their fiduciary duties, Managers should dynamically manage the funds under their management in the best interests of investors in light of the prevailing circumstances and related risks from time to time.

(ii)           Managers should ensure that there are appropriate and suitable risk management and control systems which are commensurate with a fund’s risk profile, taking into account the prevailing market conditions from time to time.

(iii)          It is the Managers’ duty to ensure that the offering documents (including the product key facts statement (“KFS”)) of the funds under their management are up-to-date and contain the information necessary for investors to make an informed judgement of the investments proposed to them.

(iv)         Managers should keep investors informed of information concerning their funds which is necessary to enable investors to appraise the position of the funds from time to time.

Given the current circumstances, Managers are urged to monitor and conduct assessment on the underlying investments of the funds under their management, and where appropriate, promptly include prominent risks disclosure in the offering documents (including the KFS) necessary to enable investors to appraise the position of the funds, including any associated risks which may have emerged under the prevailing market conditions. Disclosure in the offering documents (including the KFS) should be fair and balanced, and should not create an impression that investments in sovereign securities are safer than, or less risky than, other investments.

Investments of more than 10% of the fund’s net asset value in securities issued and/or guaranteed by a single sovereign issuer which is below investment grade by SFC-authorized funds  

Under the existing rules and regulations, Managers may have the flexibility to increase the value of the holdings of securities issued by a single sovereign issuer to over 10% of a fund’s net asset value (“NAV”). Nonetheless, they should always observe the spirit of the principle of diversification of investments, which is a fundamental principle in the management of funds offered to the public, and exercise due care and professional judgement in the selection of underlying investments to ensure that, amongst others, there is an appropriate diversification of investments in the respective funds under their management.

Justifications and required disclosure

When we process new fund applications or deal with existing SFC-authorized funds which may have investments of more than 10% of the fund’s NAV in securities issued and/or guaranteed by a single sovereign issuer which is below investment grade (“non-investment grade securities of a single sovereign issuer”), we expect the relevant Managers to confirm to the SFC with cogent reasons that it is in their professional judgment having due regard to their fiduciary duties that it will be in the best interests of investors for the fund to invest more than 10% in non-investment grade securities of a single sovereign issuer in light of the prevailing market conditions (the “Justifications”).  

Justifications to be provided by the Managers should take into account the specific circumstances of the relevant new fund under application or existing SFC-authorized fund (as the case may be) with reference to, for example, the investment objective and strategies of the fund, the identities of the relevant sovereign and expected or potential extent of investment and reasons for the concentration of the investments etc.  

In addition, we expect there should be, at a minimum, prominent disclosure in the offering documents (particularly the KFS) of the following information for better transparency:

(i)            In the “Objective and Investment Strategy” section of the KFS, detailed and clear disclosure highlighting the extent (i.e. over 10% and the maximum percentage) of potential concentration of investments in non-investment grade securities of a single sovereign issuer, the reasons for such concentration and the associated risks and potential impact on investors.

(ii)           Identities of potential sovereigns, being the relevant single sovereign issuer(s) rated below investment grade and, if applicable, a description of the benchmark together with the relevant benchmark constituents should also be disclosed.  For the avoidance of doubt, if the reason for the fund’s investment of more than 10% of its NAV in non-investment grade securities of a single sovereign issuer is a result of general reference to certain benchmark, such benchmark should be disclosed under the section headed “Objective and Investment Strategy” of the KFS.

(iii)          In the “key risks” section of the KFS, clear and prominent risk disclosure should be made regarding the risk of high concentration (including specific names of potential sovereigns involved) and the impact on the risk profile of the fund, as well as the risk of default of the sovereign issuer(s) resulting in significant losses to investors.

We also expect the key risks referred to in (iii) above should be prominently disclosed in the risk disclosure box in the marketing materials of the relevant fund.

For the purpose of this circular, “securities issued and/or guaranteed by [a] single sovereign” refers to securities “issued and/or guaranteed by government, public or local authority” and would not include “quasi-government” securities or securities issued and/or guaranteed by issuers which are separate legal entities having their own balance sheets and assets, while at the same time being government-owned or related entities.  In addition, the “credit rating” of the sovereign issuer should in general refer to the prevailing official credit rating of the relevant sovereign issuer assigned by an internationally recognized credit agency and, in the event of split ratings among such credit agencies, the highest credit rating accredited to the relevant sovereign issuer shall be deemed the reference credit rating for this purpose. For the avoidance of doubt, securities issued by an unrated sovereign issuer (i.e. a sovereign issuer with no credit ratings being assigned as mentioned above) will generally be considered as non-investment grade sovereign securities for this purpose.

Disclosure by new fund seeking applicationswhich may invest more than 10% in debt securities

For a new fund seeking authorization which may invest more than 10% in debt securities, it is expected the relevant Manager should disclose in the offering documents (including the KFS) if the fund may invest more than 10% of its NAV in non-investment grade securities of a single sovereign issuer in order to enable investors to make an informed investment decision and for better transparency. If the fund may have such concentration, the Justifications and required disclosure mentioned above will apply.

Disclosure by existing SFC-authorized funds which may invest more than 10% of the Fund’s NAV in non-investment grade securities of a single sovereign issuer

For existing SFC-authorised funds, Managers should review their underlying funds’ investments and disclosure in the offering documents (particularly the KFS) in light of applicable regulatory requirements including the principles mentioned in this circular.  If a fund may invest more than 10% of its NAV in non-investment grade securities of a single sovereign issuer, the Justifications and the required disclosure mentioned above will apply.

General

In addition to the above, Managers are expected to establish and put in place an effective business continuity plan to deal with potential contingency situations with a view to protecting the funds from adverse impact resulting from any major market events.

Please note that the items set out above are by no means exhaustive. It is incumbent upon the Managers to properly monitor and manage the risks of the Funds and to take prompt and effective measures to reduce and mitigate any potential market and other risks that emerged from time to time faced by the Funds. 

Last but not the least, we note that, like any other financial regulators, in order to ensure effective regulation and the proper discharge of our statutory functions in a timely manner, the SFC may have to step up its disclosure and other regulatory requirements in view of prevailing market conditions and emerging risks or issues. The SFC will have regard to the spirit as well as the letter of relevant regulations in considering products authorization applications and whether products should remain authorized.

Please contact the relevant case officers in charge in case of doubt.

Investment Products Department
Securities and Futures Commission