LegCo Subcommittee on MPF System
Information Note
Investment Restrictions and Guidelines

Purpose

This paper presents a comprehensive summary of investment restrictions and guidelines for MPF investments, comprising -

  1. application of restrictions and guidelines (paragraph 2 below);
  2. general restrictions (paragraph 3 below);
  3. permissible investments (paragraphs 4 to 14 below);
  4. derivatives (paragraphs 15 to 19 below);
  5. non-permissible investments (paragraphs 20 to 25 below); and
  6. breach of investment limits (paragraphs 26 to 29 below).

Proposals

Application of Restrictions and Guidelines

2. We propose that the restrictions and guidelines should apply to the investment holdings (excluding the underlying investments of pooled investment vehicles which are already subject to the restrictions and guidelines separately) -

  1. for a scheme with no member’s choice : the scheme as a whole; and
  2. for a scheme with member’s choice : each member choice fund as a whole.

(Note: an MPF fund refers to the scheme, or in the case of a scheme with member’s choice, each member choice fund.)

General Restrictions

3. In general, an MPF fund -

  1. may not hold more than 10% of any class of security issued by any single issuer;
  2. may not have more than 10% of its total assets in the securities issued by any single issuer (other than as permitted under paragraph 5 for government and other public securities);
  3. may not make short sales; and
  4. may not borrow for investment purposes (other than as proposed in Paper 10).

Permissible Investments

Bonds and Other Debt Securities

4. We propose that bonds or other debt securities should be restricted to those meeting either one of the requirements in (a) and (b) below -

(a) meeting any one of the following minimum ratings -


Credit Rating Agency

Long Term
(one year or over)

Short Term
(less than one year)


Moody’s

Baa2

Prime-2


Standard and Poor’s

BBB

A-2


IBCA

BBB

A2


JBRI

A-

A2

(b) issued by, or on which the payment of principal and interest is guaranteed by -

  1. in Hong Kong : the Government of Hong Kong, the Exchange Fund established by the Exchange Fund Ordinance or a company in which 100% of the shares are owned beneficially by the Government of Hong Kong; or
  2. outside Hong Kong : the government, the central bank or an equivalent agency of a country, or a multilateral agency which qualifies for a credit rating of ‘AAA’ given by Standard and Poor’s on its long term debt (or equivalent).

5. The concentration limit referred to in paragraph 3(b) will be relaxed in respect of government and other public securities qualified under paragraph 4(b) as follows :

  1. up to 30% of a fund’s total assets may be invested in securities of the same issue; and
  2. a fund may invest all of its assets in these securities but spread out amongst at least six different issues.

Equities

6. We propose that investment in equities should only be allowed in fully paid-up shares listed on recognised stock exchanges (Annex A). However, as provided in paragraph 14, up to 10% of a fund’s assets could be invested in shares listed on stock exchanges outside the list. This proposal addresses the concern for sufficient liquidity for the trading of equities and reliance on the disclosure requirements of the exchanges.

Convertibles

7. Because of the hybrid nature of convertibles, we propose that they may be regarded as bonds (paragraphs 4-5 above) having to meet the minimum credit ratings applying to bonds, or be listed on recognised exchanges.

Warrants

8. Since most warrants are highly leveraged investments, we propose that investments in warrants, including covered warrants, should be limited to 5% of a fund’s assets. Warrants that have put features are non-permissible except for the purpose of hedging.

Bank Deposits

9. We propose that :

  1. deposits may only be made with authorized institutions within the meaning of the Banking Ordinance, and foreign banks with a minimum short-term rating of ‘A-1’ given by Standard & Poor’s (or equivalent);
  2. up to 10% of a fund’s assets can be deposited with a single banking institution and up to 25% for a group of associated institutions;
  3. for small funds up to HK$8 million, the deposits with any single banking institution can be relaxed to 25% of a fund’s assets; and
  4. total amount of deposits with any single banking institution should not exceed 5% of its capital base.

Underwriting and Initial Public Offerings (IPO)

10. We propose that the investment manager, subject to the prior approval of the trustee, may make arrangement for a fund to -

  1. sub-underwrite shares to be listed on a recognised stock exchange or bonds meeting the minimum credit ratings; and
  2. apply for shares in an issue seeking a listing on a recognised stock exchange.

Securities Lending

11. We propose to allow securities lending subject to the following conditions :

  1. security lending shall only be conducted through the custodian under a specific mandate from the trustee;
  2. there is clear legal agreement which forms part of the custodial agreement authorizing the custodian to lend securities;
  3. lending on a no-name basis is not permissible that is where the identity of the borrower is undisclosed;
  4. collateral with sufficient margin over the value of the lent security shall be either cash or a Hong Kong Government or ‘AAA’ rated government debt which has a remaining maturity of no longer than 3 years;
  5. the collateral should be marked to market on a daily basis;
  6. cash collateral should be
    1. invested in either a Hong Kong Government or ‘AAA’ rated government or public security of term no longer than one year; or
    2. deposited with a qualified banking institution;
  7. the fund’s exposure to counterparties should be monitored on a daily basis;
  8. no more than 10% of a fund’s assets may be on loan at any time; and
  9. no more than 50% of each individual holding may be on loan at any time.

Repurchase Agreements (Repo)

12. We propose to allow bond repurchase (repo) agreements subject to the following conditions :

  1. repo shall only be conducted through the custodian under a specific mandate from the trustee;
  2. there is clear legal agreement which may form part of the custodial agreement authorizing the custodian to repo bonds;
  3. payment for the bond shall be either in the currency of the bond loaned, US dollar or HK dollar and
    1. invested in either a Hong Kong Government or ‘AAA’ rated government or public security of term no longer than one year; or
    2. deposited with a qualified banking institution.
  4. the fund’s exposure to counterparties should be monitored on a daily basis;
  5. no more than 10% of a fund’s assets may be used in repurchase agreements at any time;
  6. no more than 50% of each individual holding may be used in repurchase agreements at any time; and
  7. reverse repo agreements are not permissible.

Foreign Currency Exposure

13. We propose to limit the foreign currency exposure to 70% of the fund assets. We would allow hedging of the currency risk of foreign currency assets into Hong Kong dollars for the purpose of determining compliance with the limit.

Other Securities

14. Up to 10% of a fund’s assets can be invested in :

  1. shares listed on stock exchanges outside the recognised list; or
  2. securities that derive their value from basic building blocks consisting of equities or bonds provided that they are listed on recognised stock exchanges and the underlying securities are also listed.

Derivatives

Restricted Usage

15. We propose that financial derivatives may be used but limited to financial futures and options traded on recognised futures exchanges (see Annex B) and for the purposes of -

  1. hedging existing positions in a portfolio, where there is a strong correlation to the underlying investments; and
  2. tactical asset allocation or efficient portfolio management, provided that derivatives are not used -
    1. in excess of 10% effective exposure of the fund (i.e. participation in price movement of equivalent quantity in physical stocks); and
    2. to gear the overall portfolio, i.e. leveraging.

SFC Vetting of Specialist Expertise

16. We propose that derivative investments of MPF funds should be managed by investment managers and monitored by trustees whose qualifications to operate derivative funds have been vetted by the SFC.

Inspection of Controls and Compliance by Auditors

17. The trustee is required to file a report to the MPFA on the proper control and supervision over scheme operation including investment of assets. The report sets out the control objectives and the controls and procedures to achieve these objectives. Auditors will be required to express an opinion in respect of the trustee’s report, opining as to the existence and effectiveness of controls and procedures and whether they are adequate to meet the objectives. We propose that this report should cover the area of investment in derivatives.

The Statement of Investment Policy and Objectives

18. We propose that the policy and guidelines regarding derivatives activities should be disclosed in the scheme’s statement of investment policy and objectives.

Hedging Foreign Currency Risks

19. For the purpose of hedging currency, forward contracts should not exceed twelve months and must be executed through an authorised banking institution in Hong Kong.

Non-Permissible Investments

Disallowed Investments

20. Any investments other than those mentioned above will be disallowed.

Geared Investment Vehicles

21. Since the risk profile of an investment vehicle is increased by gearing, we propose not to permit investment vehicles that borrow to increase their invested assets.

Commodities, Commodity Funds

22. An MPF fund may not invest in commodities or commodity based investments because of the liquidity and valuation problems and their highly speculative nature.

Property

23. Because of the illiquid nature of property and the lack of readily available market values, an MPF fund should not hold direct investments in property.

Loans, Mortgages and Debts

24. Loans, mortgages and debts are not common investment tools for provident funds due to liquidity and valuation problems. As such, an MPF fund should not make a loan nor engage in any mortgage lending or debt instruments other than those allowed under debt securities and bank deposits.

Jewellery, Works of Art and Collectibles

25. Jewellery, works of art and collectibles should not be allowed.

Breach of Investment Limits

Breach of Investment Limits in MPF Restrictions and Guidelines

26. We propose that when the investment limits in the MPF investment restrictions and guidelines are breached -

  1. if the breach occurs as the result of changes in market prices or cash inflows/outflows, no person shall be liable for the breach;
  2. if the breach occurs as a direct result of the actions of the trustee or the investment manager, then any losses of scheme assets should be compensated by the trustee or the investment manager as appropriate; and
  3. the trustee or the investment manager should take as priority objective all steps as are necessary within a reasonable period of time to remedy the situation, taking due account of the interests of scheme members.

27. We propose that losses to scheme assets caused by misfeasance or illegal conduct should be covered by the Compensation Fund only if the trustee or investment manager and their professional indemnity insurance and performance guarantee are unable to make up such losses.

Breach of Investment Limits of Investment Management Agreement

28. We propose that when the investment limits in the investment management agreement which are additional to those restrictions and guidelines issued by the MPFA are breached by the investment manager -

  1. if the breach occurs as the result of changes in market prices or cash inflows/outflows, no person shall be liable for the breach;
  2. if the breach occurs as a direct result of the actions of the investment manager, then any losses of scheme assets should be compensated by the investment manager; and
  3. the investment manager should take as priority objective all steps as are necessary within a reasonable period of time to remedy the situation, taking due account of the interests of scheme members.

29. We propose that these investment losses should not be compensated by the Compensation Fund.

Justification

The Need for Investment Restrictions and Guidelines

30. The justifications for imposing investment restrictions and guidelines have been given in our previous information note - "Basic Approach of the MPF System : Security of Scheme Assets". The proposals in paragraphs 2 to 25 above are intended to present for the compliance of trustees and investment managers a comprehensive list of permissible and non-permissible investments.

Breach of Investment Limits

Breach of Investment Limits in MPF Standards and Guidelines

31. For those situations where the breach of limits occurs as a result of outside factors, no person shall be liable for the breach. Such breaches would result from -

  1. an appreciation or depreciation in the value of the whole or any part of the investment portfolio;
  2. variations in exchange rates; or
  3. inflows and outflows to the scheme that may materially change the invested structure of a scheme.

32. Section 7.24 of the SFC Code on Unit Trusts and Mutual Funds states that "the management company shall take as a priority objective all steps as are necessary within a reasonable period of time to remedy the situation, taking due account of the interests of the holders". We propose to adopt the same approach for these "passive" breaches.

33. In situations other than those described in paragraph 31, where the breach of limits is the result of the action or inaction of the trustee or investment manager, the trustee or investment manager as appropriate should be required to compensate the scheme for any losses that occur.

34. Where there is misfeasance or illegal conduct by the trustee or investment manager, losses to scheme assets may be covered by the Compensation Fund after exhausting the financial resources of the trustee or investment manager and their professional indemnity insurance and performance guarantee cover.

Breach of Investment Limits of Investment Management Agreement

35. The proposals in paragraph 26 should equally apply to breach of investment limits laid down in the investment management agreement.

36. However, it is possible that the investment limits stipulated in an investment management agreement may be more stringent than the MPF investment limits issued by the MPFA. Recognising the fact that the investment management agreement is a private contract between the trustee and the investment manager, any breach of contract should be resolved and dealt with by the relevant parties. It would be unfair for the Compensation Fund to cover such breaches unless the investment manager has also breached investment limits issued by the MPFA.

37. It is envisaged that the trustee will be responsible for discovering any breaches of investment limits and applying the appropriate remedies. It is likely that systems established by the custodian and the trustee will be sufficient to discover any breaches within a reasonable period of time. In addition, the auditor may discover breaches through his normal audit procedures.

Mandatory Provident Fund Office
Financial Services Branch
24 November 1996
[Ref.: Paper/MPF/SC-7]

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