PLC Sub-Committee on Subsidiary Legislation of the 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);

  2. general restrictions (paragraph 3);

  3. permissible investments (paragraphs 4 to 14);

  4. derivatives (paragraphs 15 to 18);

  5. non-permissible investments (paragraph 19);

  6. pooled investment funds (paragraphs 20 to 22);

  7. restricted investments (paragraph 23); and

  8. breach of investment limits (paragraphs 24 to 27).

Proposals

Application of Restrictions and Guidelines

2.We proposed that the restrictions and guidelines should apply to the investment holdings -

  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 unless -

    1. it is for the purposes of -

      1. making payments on the withdrawal or portability of accrued benefits (without resort to a distressed sale of the assets of the fund) provided that the borrowing is for a term not exceeding 90 days; or

      2. covering settlement of a transaction for the acquisition of investments where it was anticipated that the borrowing would not be needed at the time the relevant investment decision was made and the term of borrowing does not exceed 7 days;

    2. the amount borrowed should not exceed 10% of the value of the assets of the fund; and

    3. the borrowing is not part of a series of loans or other transactions and repayments;

  5. may not acquire an asset which involves the assumption of any liability that is unlimited and the fund may not result in a net liability to holders of the fund.

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 following requirements -

(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'sBaa2Prime-2
Standard and Poor'sBBBA-2
IBCABBBA2
JBRIA-A2

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

  1. in Hong Kong : the Government of the Hong Kong SAR, 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 the Hong Kong SAR; 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);

(c) listed on recognized stock exchanges (Annex A) and are issued by, or guaranteed by a company whose shares are so listed.

5.The concentration limits referred to in paragraphs 3(a) and 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 recognized stock exchanges. 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 (paragraph 4 above) having to meet the minimum credit ratings applying to bonds, or be listed on recognized exchanges and convertible to shares so listed.

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. Such warrants should be convertible to shares listed on recognized stock exchanges. 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;

  4. total amount of deposits with any single banking institution should not exceed 10% of its capital base; and

  5. certificates of deposits issued by an authorized institution are deemed to be bank deposits with such institution and come under the above (a) to (d) restrictions.

Underwriting and Initial Public Offering (IPO)

10.We propose that the investment manager, subject to the prior approval of the trustee and the amount of money held on deposit, may make arrangement for a fund to -

  1. sub-underwrite shares to be listed on a recognized stock exchange or bonds meeting the minimum credit ratings; and

  2. apply for shares in an issue seeking a listing on a recognized 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, a Hong Kong SAR Government or " AAA " rated government or other public security, or a security eligible for the Liquidity Adjustment Facility of the HKMA, all with 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 SAR Government or " AAA " rated government or public security of term no longer than one year; or

    2. deposited with a qualified banking institution;

  7. a 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 custody 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 SAR Government or " AAA " rated government or public security of term no longer than one year; or

    2. deposited with a qualified banking institution;

  4. a 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 a fund's assets. We would allow hedging of foreign currency assets into Hong Kong dollars by forward currency contracts with term not exceeding 12 months that are executed through authorized institutions.

Other Securities

14.Up to 10% of a fund's assets can be invested in -

  1. shares listed on stock exchanges outside the recognized list;

  2. unit trusts or mutual funds authorized by the SFC that are not Warrant Funds, Leveraged Funds or Futures and Options Funds; and

  3. securities that derive their value from basic building blocks consisting of equities or bonds provided that they are listed on recognized 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 recognized stock or futures exchanges (see Annex B) for the purpose 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 a 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 vetting by the SFC.

Inspection of Controls and Compliance by Auditors

17.The report on internal controls and the auditor's opinion in respect of such report to be filed with the MPFA should cover the area of investment in derivatives.

The Statement of Investment Policy

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

Non-Permissible Investments

19Any investments other than those mentioned above will be disallowed.

Pooled Investment Funds

20.We propose that an MPF scheme may invest in a pooled investment fund that is -

  1. a unit trust or mutual fund authorized by the SFC; or

  2. a retirement schemes policy issued by an authorized insurer.

Approval of Funds

21.We propose that the MPF Authority may approve a pooled investment fund for use by MPF schemes only if -

  1. the fund is governed by Hong Kong law;

  2. it is managed by a qualified investment manager;

  3. there is proper separation of fund assets under the trusteeship of an MPF approved trustee and/or the custody of a qualified custodian;

  4. the fund must comply with all MPF investment restrictions and guidelines; and

  5. the fund must be unitized except for non-linked pooled provident fund policies with investment guarantees.

Investment Guarantees

22.We propose to confine guarantors of investment guarantees to -

  1. authorized institutions;

  2. authorized insurer to offer retirement schemes policies with investment guarantees.

Restricted Investments

23.We propose that an employer sponsored scheme may not have more than 10% of its assets in shares or other securities of, or issued by the participating employers or their associates, including covered warrants issued by a third party on the shares of the participating employers or their associates but excluding covered warrants issued by their associates on the shares of a third party. This limitation, however, should not apply to government or public securities.

Breach of Investment Limits

Breach of Investment Limits in MPF Restrictions and Guidelines

24.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 fund 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 members of the fund.

25.We propose that losses to fund 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

26. We propose that when the investment limits in the investment management agreement which are additional to those in MPF restrictions and guidelines 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 members.

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

Justification

The Need for Investment Restrictions and Guidelines

28.The scheme members' accrued benefits should be invested prudently and not subject to undue and unnecessary risks. The restrictions and guidelines will lay down the outer limits of reasonable investment behaviour striking a balance between flexibility to achieve investment performance and safeguard against excessive risk taking. These rules are formulated based on existing good industry practices in the investment of retirement funds with reference to SFC's code for authorising unit trusts and mutual funds.

29.Qualitative restrictions will specify permissible investments based on investment grades, liquidity and valuation considerations, whilst quantitative restrictions will be placed on risky investments and to contain the risks of asset concentration. The proposals in paragraphs 2 to 19 above are intended to present for the compliance of trustees and investment managers a comprehensive list of permissible and non-permissible investments.

Pooled Investment Funds

30.Unit trusts, mutual funds and retirement scheme policies are widely used by ORSO schemes and should continue to be allowed for MPF schemes. To ensure adherence to MPF investment restrictions and guidelines and to facilitate trustees' monitoring of compliance and supervision by the Authority, these pooled investment funds should be approved by the Authority in accordance with MPF rules. The operation of these pooled investment funds should, however, continue to be subject to existing regulation by the SFC, the Insurance Authority and the HKMA with respect to their authorisation and the requirements on adequacy of reserves.

Restricted Investments

31.Many retirement schemes in Hong Kong have invested into stocks listed in the local stock exchange and such investment opportunities should be made available to the schemes of the listed companies themselves. The scheme of locally listed company may also want to invest a portion of assets into shares of the company and its listed associates in order to closely follow the performance of the local stock market. A similar case can be made for qualified debt securities of the employer or its associates. To allow flexibility, it would be reasonable to permit a small percentage of scheme assets to be invested into the listed shares and qualified debt securities of the employer or its associates. Our proposed 10% limit is adopted from the Occupational Retirement Schemes Ordinance (ORSO).

Breach of Investment Limits

Breach of Investment Limits in MPF Standards and Guidelines

32.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.

33.In situations other than those described in paragraph 32, 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.

35.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.

Breach of Investment Limits of Investment Management Agreement

36.The proposals in paragraph 24 should equally apply to breach of investment limits laid down in the investment management agreement. However, it is possible that the investment limits stipulated in an investment management agreement may be more stringent than the MPF investment limits. 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 MPF investment limits.

37.It is envisaged that the trustee will be responsible for discovering any breaches of investment limits, 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 Bureau
13 November 1997