Derivatives Exposure, a Side Letter and Smoothing the NAV
Lantau Capital (Type 9 and Type 4) manages the SFC-authorised Lantau Asian Income Fund, NAV HK$2.4 billion. To obtain exposure to mainland property bonds without buying them outright, the fund has entered total return swaps with a single dealer; the swaps produce HK$1.7 billion of exposure and the fund's net derivative exposure is 68% of NAV. It also holds 12% of NAV in one privately placed bond that takes up to 20 business days to sell. A seed investor holding 22% of units has a side letter giving 24-hour redemption and a fee rebate, while other unitholders deal at T+5. The portfolio manager proposes to value the private bond on a three-month smoothed price to reduce volatility in the NAV, and to treat the swaps as hedging because the dealer's confirmation describes them as hedging transactions. Compliance has asked for your view before the next valuation and the monthly SFC filing.
1. Is the fund's use of total return swaps compliant? What must happen now?
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The dealer's labelling is irrelevant. What matters is economic substance: the swaps create synthetic long exposure to property bonds the fund does not own, so they are investment positions, not hedges of assets already on the books. A genuine hedge would offset an existing risk in the portfolio, be documented as such, and be monitored for effectiveness.
The limit is breached. The Code on Unit Trusts and Mutual Funds caps a fund's net derivative exposure at 50% of NAV. At 68% the fund is outside that cap. The breach cannot be cured by re-describing the swaps.
Immediate steps.
- Stop adding exposure and reduce the swap notional to bring NDE back within 50%, or amend the investment policy and obtain unitholder approval if the strategy genuinely requires more.
- Notify the SFC promptly, with a rectification plan, timetable and root-cause analysis.
- Check that the offering document, the investment policy and the constitutive documents actually permit total return swaps and this asset class at all.
- Address counterparty concentration: a single dealer for the whole exposure creates credit and collateral risk that must be managed with ISDA documentation, collateral terms and independent monitoring.
- Review how NDE is calculated and reported; if the monthly filing understated it, correct the position proactively rather than waiting to be asked.
2. Assess the illiquid bond holding and the seed investor's side letter, including the liquidity risk to the fund.
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The holding limit is breached. A position of 12% of NAV in a bond that takes up to 20 business days to sell exceeds the 10% limit on illiquid assets. This must be reported, rectified within a stated period, and disclosed appropriately.
The side letter is the more serious issue. One unitholder holding 22% gets 24-hour redemption while everyone else deals at T+5. That is unequal treatment, it gives the seed investor a first-mover advantage over the fund's illiquid assets, and it converts a liquidity mismatch into a run risk: the seed investor can exit at a NAV that reflects a bond price the fund cannot realise within 24 hours. The cost of that exit is borne by the remaining investors.
Expectations. Preferential treatment must be disclosed, approved and monitored under the Fund Manager Code of Conduct and the Code on Unit Trusts and Mutual Funds, and it must not disadvantage other investors. The manager should:
- Review whether the side letter can be terminated, varied or at least fully disclosed in the offering document.
- Run redemption stress tests (seed investor exits, 20% and 40% of units redeemed) against the fund's liquid assets.
- Confirm that any suspension, gating or side-pocketing is permitted by the constitutive documents and disclosed in advance, not invented at the moment of stress.
- Report the arrangement and the plan to the SFC rather than letting it be discovered at inspection.
3. Can the manager value the private bond on a three-month smoothed price? Advise on valuation, performance fees and disclosure.
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No. Smoothing does not remove volatility; it hides it. An investor redeeming during a rising market receives a price below realisable value, and one redeeming during a falling market receives more than the assets are worth. Value is transferred between continuing and exiting unitholders, and the NAV reported to the SFC and to the market is inaccurate.
What fair valuation requires. The bond should be marked at fair value using a documented, consistently applied methodology: recent comparable transactions, independent broker quotes, or a discounted cash flow using an appropriate credit spread and recovery assumption. Because the instrument is illiquid and the portfolio manager's fee depends on NAV, the valuation should be reviewed by an independent valuation committee or pricing function, with the PM's input documented but not decisive.
Performance fee. The fee must be calculated on the properly valued NAV. Paying a fee on a smoothed NAV overstates both the fee and the manager's apparent performance, and can amount to a breach of the management agreement and the Code.
Disclosure and governance. Any change to the valuation policy requires board approval, consistency with the fund's constitutive documents and accounting standards, and communication to unitholders. The conflict of interest should be disclosed in the offering document. Correct the current NAV, quantify the effect on past fees, and consider whether remediation to unitholders is required.