For a fund created out of necessity, Hong Kong's Tracker Fund has proved remarkably successful. It has enabled the government to dispose of its controversially acquired share portfolio without market disruption; it has returned shares to the market; and it has risen 20 per cent since launch.

The tracker fund owes its existence to the market turmoil that swept Hong Kong during the Asian financial crisis. The government, which has long prided itself on its free market credentials, launched an unprecedented share-buying spree in August 1998 in a bid to frustrate speculators and return stability to financial markets, which had come under heavy pressure.

The move gave rise to concerns over conflicts of interest: the HK$118.1bn spending spree gave the government stakes of more than 10 per cent in three companies, and smaller holdings in the remaining 30 benchmark Hang Seng Index constituent stocks.

There were also fears of the impact the ultimate disposal would have on the market. Hong Kong always made clear it did not plan to be a long-term holder of the portfolio, but was equally determined that the eventual sell-off would not disrupt the market.

With these aims in mind, the Tracker Fund of Hong Kong (TraHK) was launched in November last year. The fund, which tracks the Hang Seng Index - and is essentially composed of the shares bought by the government in 1998, although the original portfolio has been altered to reflect subsequent changes on the Index - was hugely popular with the public, prompting a trebling of the initial public offer size.

By November 1999, the rise in the market had swollen the value of the government portfolio to about HK$215bn. The government initially planned to sell HK$10bn of that, opting for a more modest portion in part due to Hong Kong's traditional reluctance to buy unit trust-style products.

In the event, however, the IPO size was raised to HK$33.3bn, making it the biggest IPO in ex-Japan Asia. Total subscription for the offering was HK$48.3bn, with retail demand accounting for HK$28bn.

The units of the fund were priced at HK$12.88, a discount of 5.25 per cent to the average price per unit on the three days preceding launch and at the low end of the 5 to 8 per cent discount range earlier signalled by the government.

The fund also offered loyalty bonuses for local investors willing to hold the units for two years, which, added together with the upfront discount, worked out to an effective aggregate discount of more than 16 per cent.

The units surged 9 per cent on their debut on November 12. As well as using incentives to woo investors, the government and its advisers were careful to construct a disposal programme that could be continued and which would not panic the market.

A crucial component in delivering on this last objective is the so-called Tap mechanism, where new units are offered for cash, with a quarterly limit set on the maximum number of units available.

According to Hong Kong research analysts at Deutsche Bank, early concerns that the Tap could be a significant overhang on the market proved misplaced. In fact, since the initial offer, a further 995m units have been issued through the tap (while 1,758m units have been redeemed).

The German bank says: "Clearly, the government is comfortable with the success of the Tap, hence the announcement that the Tap for the second quarter of 2000 will be 715m units with a value of approximately HK$12bn."

Vincent Duhamel, chief executive of State Street Global Advisors, manager of the fund, says the fund ensures fair pricing through the "in kind creation and redemption" mechanism.

He adds: "Whenever the fund trades at either a discount or premium, those guys (institutions) come in and arbitrage the positions away to bring it back to fair value.

The average discount is around 40 basis points, largely due to stamp duty." However, the fund has not completely escaped the attention of critics, some of whom point to the high level of redemptions. These stood at 2.3bn units as against 1.7bn units created, which means net redemptions account for around one quarter of the fund.

According to Mr Duhamel, this is evidence of how perfectly the system works. He says that in the case of a closed-end fund, traded on a stock exchange, the price would fall sharply after the IPO if, in order to benefit immediately from the discount to NAV at which such funds are typically offered, investors liquidated their holdings.

"In this case, we have had redemptions but everyone was able to get out successfully without taking a discount," he says. Indeed, many have come out with gains of between 20 to 30 per cent.

Deutsche Bank estimates the TraHK has generated close to HK$20bn in profits for the government, and reckons the government has now sold around one-quarter (measured by cost) of the controversially acquired share portfolio.


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