Fund Times: Will It Last?

Cheah Meng Choo continues her discussion on Exchange Traded Funds in the second part of this two part series

 

INTRODUCTION

 

The prequel to this article introduced the readers to the somewhat unfamiliar concept of Exchange Traded Funds ("ETF") in Malaysia. In this article, we shall explain how ETFs are created and discuss the roles of the main participants as well as the regulatory aspects relating to the management of ETF.

 

The Securities Commission ("SC") is the regulatory body responsible for the regulation of all matters relating to ETF. The primary legislation that regulate ETF are the Securities Commission Act 1993 ("SCA") and the Securities Industries Act 1983 ("SIA"). Of equal importance are the Guidelines on Exchange Traded Funds ("ETF Guidelines") issued by the SC.

 

THE PRINCIPAL PLAYERS

 

In a nutshell, the main parties involved in ETF and their principal roles are as follows:

  • the management company who is responsible for the management and the administration of the ETF;
  • the trustee who acts as the custodian of the fund's assets and safeguards the interest of the unit holders;
  • the participating dealers who are responsible for the creation of the fund; and
  • the unit holders who are the persons who invest in the fund.

 

The rights and responsibilities of these parties will be dealt in further detail in this article.

 

LIGHTS, CAMERA, ACTION! THE MAKING OF AN ETF

 

The creation of ETF units begins when a participating dealer assembles a basket of securities (“index basket”) and deposits it with the trustee through management company. The index basket is determined by the management company.

 

Upon receipt of the index basket, the trustee creates a specified number of new ETF units and forwards them to the participating dealer who is free to sell such units in marketable lots on Bursa Malaysia Securities Berhad.

 

The trustee will hold the index basket in the fund’s account for the management company to manage in a passive manner.

 

ROLES OF THE PLAYERS

 

Management Company

 

An ETF is managed and administered by a management company approved by the SC under the SCA. Unless otherwise permitted by the SC, the management company is required to be a subsidiary or related corporation of a company involved in the financial services industry in Malaysia. ‘Financial services’ business includes (but is not limited to) deposit-taking and provision of loans (including commercial/retail banking and finance company activities), fund management, merchant banking, broking and dealing in securities and insurance activities.

 

The management company is required to have at least 30% Bumiputera equity. Foreign equity participation is restricted to 49%. Unless otherwise approved by the SC, the activities of the management company must be restricted to managing the investment portfolio and administering unit trust funds, marketing and distributing unit trust funds, providing investment advisory services and if it is a universal broker, activities which a universal broker is permitted to undertake.

 

The principal duty of the management company is to manage and administer the ETF in a proper, diligent and efficient manner in accordance with the trust deed of the fund, the ETF Guidelines, securities laws and acceptable and efficacious business practice within the unit trust industry.

 

A management company is required to manage the ETF to the best and exclusive interests of the unit holders. Other duties of the management company include ensuring that the fund or units of the fund are correctly valued, informing the trustee of any acquisition or disposal of investments of the fund and maintaining proper accounting records.

 

The board of directors of the management company must at all times have at least two independent members and maintain a ratio of at least one-third of independent members. The chief executive of the management company should be a full-time officer of the company whose appointment is subject to approval by the SC. The management company is required to have suitably qualified and experienced personnel to carry out its investment management function and to head the compliance unit which is responsible for the management company’s compliance with all applicable legal and regulatory requirements and internal policies and procedures.

 

Trustee

 

An ETF must appoint a trustee approved by the SC under the SCA. The trustee must be a trust company registered under the Trust Companies Act 1949 or incorporated pursuant to the Public Trust Corporation Act 1995 and registered with the SC. The trustee must be independent of the fund and must not on its own behalf, hold units or other interests in the fund. The primary responsibilities of the trustee are to act as custodian of the assets of the fund and to safeguard the interests of the unit holders of the fund.

 

The trustee should actively monitor the administration of the fund by the management company and act with due care, skill, diligence and vigilance. The trustee must be informed of the investment policies established by the management company for the fund and of any changes thereto. It is required to notify the SC immediately of any irregularity in the fund.

 

Investment Committee

 

The management company must establish an investment committee for the fund that comprises at least three individuals whose appointment must be approved by the SC. The investment committee oversees the investment decisions and management by the management company to ensure that they are consistent with the objectives of the ETF, the constituent documents of the fund, internal policies, securities laws and the ETF Guidelines. The investment committee’s powers and duties include ensuring that the strategies selected are implemented properly and actively monitoring and evaluating the investment management performance of the management company or its delegate.

 

Participating Dealers

 

Participating dealers are responsible for the creation and redemption of fund units and are appointed by the management company. A participating dealer deals in the market for the fund either as a principal or on behalf of clients. The participating dealer must comply with the terms of the participating dealer agreement entered into with the management company to regulate the procedures for the creation and redemption of ETF units.

 

The redemption of ETF units involves the delivery by the participating dealer to the trustee of the number of ETF units specified by the management company, in exchange for which it receives a basket of securities of equivalent value to the redeemed units. The basket of securities may thereafter be sold by the participating dealer on the appropriate secondary market.

 

[SHARING THE SPOTLIGHT / THE SUPPORTING ACTOR]

 

Any delegation of the management company’s functions requires the approval of the SC, the only exception being the delegation of investment management function to a fund manager licensed under Section 15A of the SCA, which does not require such approval. An investment management agreement is usually entered into between the fund manager and the management company for providing the fund management services.

 

The management company must ensure that the delegate is competent to undertake the functions in a proper and efficient manner. It must also take full responsibility for the acts and omissions of the delegate and is not entitled to charge the remuneration of the delegate to the fund.

 

THE SCRIPT - FUND DOCUMENTATION

 

The trust deed is entered into between the fund manager, the trustee and the unit holders. The terms and conditions of the trust deed and any supplemental deed is binding on each unit holder as if he had been a party to and executed this deed and had authorized the trustee and the fund manager to do all acts and things as the deed may require. The trust deed and any supplemental deed must be registered by the SC. The trust deed describes how the ETF operates and sets out the rights and liabilities of a unit holder as well as the duties and obligations of the fund manager and trustee. Each unit held in the fund entitles the unit holder to an equal and proportionate beneficial interest in the fund. A unit holder has the right to receive income distribution (if any), sell fund units, attend and vote at meetings and receive annual and interim reports of the fund. A unit holder may, subject to the provisions of the trust deed, have a right to call for meetings of unit holders. The trust deed limits the unit holder’s liability to the value of their investments in the fund.

 

The prospectus is a document containing detailed information which enables the investors to make an informed assessment of the fund before investing in it. The prospectus and any supplementary prospectus must be registered with the SC. The information which is disclosed in the prospectus includes the investment objectives of the fund namely, the underlying index which the fund intends to track or replicate, the investment strategies, circumstances that may lead to tracking errors, risk factors in investing in the fund, the fund’s performance (where the fund has been in operation for at least one financial year), fees, charges and expenses of the fund. A prospectus, being full of legalese, may be hard reading but an investor should go through its fine print to ascertain whether his goals and expectations match the objectives of the fund.

 

The management company is required to provide at least two fund reports, namely an interim report and an annual report, for each financial year of the fund. The purpose of these reports is to enable unit holders to evaluate the fund’s performance during the relevant period. Both reports must include a manager’s report which contains a review of operations of the fund, results of those operations and details of any significant changes in the affairs of the fund during the financial period and a trustee’s report which sets out the opinion of the trustee whether the fund has been managed in accordance with the Guidelines, trust deed and securities law, whether valuation requirements have been complied with and whether the creation and redemption of ETF units have been carried out in accordance with the trust deed and any regulatory requirements. The fund reports must be published, distributed to the unit holders and lodged with the SC within two months from the end of the financial period covered by the reports.

 

The annual report and interim report must include the financial statements of the fund. The financial statements included in the final report must be audited by an approved company auditor who is independent of the management company and the trustee. There is no requirement for the financial reports included in the interim report to be audited. These documents are to be made available for the investor’s perusal at the management company and the trustee’s place of business.

 

The management company is also required to lodge its annual report with the SC within six months after its financial year-end and to make the same available to the unit holders within two months of any request being made for the same.

 

A BOX OFFICE HIT?

 

The introduction of ETFs adds further variety to the types of collective investment schemes available to investors in Malaysia. The question that remains to be answered is whether it will become a box office hit.

 

Cheah Meng Choo ( This e-mail address is being protected from spambots. You need JavaScript enabled to view it )

 
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