INDEX TRACKER FUNDS LAUNCHED

07/01/2003

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Taiwan's first exchange-traded fund, the Polaris Taiwan Top 50 Tracker Fund (TTT), began trading on the Taiwan Stock Exchange in July 2003. An exchange-traded fund (ETF) tracks the performance of a particular securities index, so that the fund's market price can closely follow its net asset value (the market value of the portfolio of indexed shares that the ETF represents).

An ETF is structured as an open-ended trust fund that practices index securitization, and it pro-vides a mechanism for shares in the fund to be purchased and redeemed in kind, in a way not offered by other trust funds. "Purchase in kind" means that the investor transfers a basket of shares to the ETF management company, com-posed of shares in a fixed ratio according to their weighting in the relevant index, along with a cash (if any) which makes up the difference between the total value of the closing prices of a basket of shares and its net asset value on the purchase day, i.e., a cash difference; and the management company creates new ETF units, which it transfers to the investor's account at a centralized securities depository. The redemp-tion mechanism is the reverse of the purchase mechanism: the investor transfers the minimum ETF unit, or an integer multiple of the minimum, to the fund management company, and the management company transfers shares to the investor's account at a centralized securities de-pository, in a fixed ratio according to their weighting in the relevant index, along with a cash difference. Both purchase and redemption are transacted "in kind", i.e. with physical shares rather than cash.

In view of the above characteristics of ETFs, to facilitate their market launch the Securities and Futures Commission (SFC) has made amend-ments to various pieces of securities and in-vestment trust regulations. The major changes are outlined below:

I.Amendments to Regulations Governing Securities Investment Trust Funds

ETF redemption procedures are exempted from some provisions of the regulations (e.g. the requirement that the redemption price of a beneficiary certificate should be calculated on the basis of the net asset value of the securities investment trust fund on the day after the written or electronic redemption request reaches the securities investment trust enter-prise or its agent). Instead, the redemption procedures may be defined by the securities investment trust agreement between the in-vestors and the securities investment trust en-terprise.

II.Day trading of ETF securities allowed

On 29 April 2003, the SFC issued an order stat-ing that in accordance with the terms of a secu-rities investment trust agreement, an investor may acquire beneficiary certificates representing a basket of shares plus the share portfolio con-sisting of the shares bought on the previous day, borrowed and/or already held by the investor, and may sell such beneficiary certificates on the same single day; and an investor may redeem the shares represented by beneficiary certificates purchased plus the beneficiary certificates bought on the previous day and/or already held by the investors, and may sell the shares acquired by such redemption on the same single day.

The order also exempts securities firms, when trading in ETF beneficiary certificates on their own account, from the provision of the Rules Governing Securities Firms that forbids a secu-rities firm to quote for the sale of securities that it does not hold.

III.ETF management companies can lend securities holdings

To facilitate the purchase and redemption in kind of ETF beneficiary certificates, on 30 April 2003 the SFC issued an order exempting ETF man-agement companies from the prohibition under Article 12 of the Regulations Governing Securi-ties Investment Trust Funds on lending to third parties securities held by such management companies. However, a management company must comply with the following requirements:

Only securities included in the index tracked by the ETF may be lent.

A borrower may only borrow securities for the purpose of purchasing units in the ETF con-cerned.

The management company must conclude a written share lending agreement with the bor-rower, which should include the matters re-quired by the SFC.

The number of shares lent in any one loan must be at least one trading unit (1000 shares).

The lending period shall not exceed 10 work-ing days starting from the day of the loan.

The number of shares of a single company lent by a single ETF shall not exceed 25% of the total shares of that company held by the ETF, and the cumulative number of shares of a sin-gle company lent to a single borrower by an ETF shall not exceed 10% of the total shares of that company held by the ETF.

The collateral provided by a borrower must be cash.

When borrowing securities a borrower must pay collateral to the ETF, in the amount of 125% (the required collateral ratio) of the closing price of the securities concerned on the date of the loan multiplied by the number of shares borrowed.

Each business day, the ETF will calculate the value of the balance of securities not yet re-turned by each borrower, at the securities' most recent stock market closing prices. If the remaining amount of the collateral provided by a borrower is less than 110% (the minimum collateral rate) of the newly calculated value of the unreturned securities, the ETF needs to issue a supplementary payment notice to the borrower, instructing the borrower to pay in additional funds, on the business day follow-ing the date of the notice, to bring the collat-eral up to 125%.

IV. QFIIs may short sell ETF securities

In an order dated 5 May 2003, the SFC also re-laxed the restriction on foreign investors selling securities that they do not hold, under the Regu-lations Governing Investment in Securities by Overseas Chinese and Foreign Nationals. Under the order, the above restriction does not apply when a qualified foreign institutional investor (QFII) instructs a single participating securities firm to purchase in kind the beneficiary certifi-cates of an ETF, either by buying the share portfolio represented by the beneficiary certifi-cates on a single day through a single account, and/or by using the aggregate of the QFII's ex-isting holdings of the share portfolio and the balance of its purchases of the portfolio the pre-vious day, and the QFII sells the beneficiary certificates so purchased. Nor does the restric-tion apply when a QFII instructs a single par-ticipating securities firm to redeem ETF benefi-ciary certificates in exchange for the share port-folio represented by them, either by purchasing the beneficiary certificates on a single day through a single account, or by using the aggre-gate of the QFII's existing holdings of such beneficiary certificates and the balance of those purchased the previous day, and the QFII sells the share portfolio so redeemed.

V.Exemption from prohibition on short sell-ing below the previous day's closing price

Because an ETF tracks a particular index, and its market price remains close to the net asset value of the fund, it is an effective tool for hedging and arbitrage by institutional investors, in addition to futures indices. What enables the market price of the tracked index to closely follow the net asset value of the fund is the fact that when an ETF is priced at a discount or at a premium, opposing arbitrage transactions take place, rapidly reduc-ing the discount or premium and thus bringing the ETF's market price back into line with its net asset value. Therefore, to avoid imbalance caused by inappropriate price control measures, and so to allow the ETF trading mechanism to operate efficiently, the SFC has relaxed its short selling price controls, in order to prevent the pressure to reduce premium pricing of an ETF from being weaker than the pressure to reduce discount pricing.

The SFC stated in a news release dated 6 May 2003 that when an investor gives instructions to short sell ETF units, the usual prohibition on short selling below the previous day's closing price does not apply. The order also exempts entities other than QFIIs that qualify for partici-pation in the securities borrowing and lending system from the rule forbidding short selling below the previous day's closing price when short selling ETF units.