For professional clients only

Index Tracker FundsAn Introductory Guide

HSBC Global Asset Management has a well-established track record in passive investments. It was a pioneer in the UK

market launching one of the very first index tracker funds in the country.

The world of passive investing has grown and evolved and we have evolved with it.

As with any experienced fund provider, over the years we have learned many lessons, honing and refining our product range in

the process.

This guide highlights some of the key questions that we believe asset allocators should consider before selecting an index

tracker fund.

Guide to Index Tracker Funds 3

What is an Index Tracker Fund?

An index tracker fund aims to replicate the returns of a given

index as closely as possible, by investing in the securities that

make up the given index.

A key advantage of this approach, compared to actively-managed

funds, which aim to outperform a benchmark, is that it eliminates

the risk of significant underperformance of the index in question.

Who should consider investing in Index Tracker Funds?Investors who:

` have a positive long-term outlook for a particular

market, such as European or Emerging Market

equities

` would like to take a shorter-term tactical call on a

particular market (eg the US or the UK) or a specific

sector within a single country (eg mid caps or large

cap stocks within the UK market)

` are comfortable with being tied to the performance

of one index

` prefer the transparency that comes with meticulously

following the performance of that index

` are prepared to take on market risks in order to grow

their wealth

` prefer a more diversified way to invest compared to

a focused portfolio or single stocks

` do not feel comfortable with entrusting the

performance of their portfolio to a fund manager

aiming to deviate from the performance of the

underlying market

Sticking with the marketAn index fund will provide exposure to individual constituent

companies and their industries in the proportions in which they

are reflected in the Index. Hence the performance of any index

constituent would be reflected equally in the performance of

both the underlying index and the index fund. An index fund

manager will not vary the fund weights from the underlying index

and will not, for example, increase its exposure to cash if the

market is expected to fall.

Equally, index fund managers will not seek to vary exposures

to certain companies or whole sectors in order to reduce

concentration risks. For example, five energy companies and five

banks make up 26.9% of the FTSE 100 Index1. Depending on the

outlook for the energy sector and other areas of the underlying

market, the level of risk in the Index Fund will rise or fall in line

with the risk in the Index and the manager will have no discretion

to vary that.

1 The five oil & gas sector constituents accounted for 14.1% and the five banking sector constituents accounted for 12.8% of the FTSE 100 Index as at 31 January 2015. Source: FTSE.

4 Guide to Index Tracker Funds

2 Monthly factsheet for the, FTSE North America Index as at 27 February 2015

Different index providers have different criteria for including

stocks. Subsequently, indices are not the same. While some

indices may cover the same region, country or an asset class

as a whole, differences in classification and rules often lead to

differences in composition and performance.

Ultimately, there are no rules set in stone on how stocks should

be categorised. Hence, there is a degree of subjectivity in how

each index provider chooses to represent a certain market.

Investors must be mindful that while some indices may have

similar names and would seem to reflect the composition

and performance of the same market, their risk and return

characteristics can be different.

For example, some providers, such as MSCI, include Real

Estate Investment Trusts (REITs) and preferred shares with

equity characteristics in their indices. In contrast, FTSE does

not consider those investment securities, which in this instance

would lead to a smaller property sector exposure. Providers also

use different methodologies to identify and separate large cap

stocks from the rest. A number of indices automatically exclude

newly-listed companies, while requirements in respect to the

level of liquidity for a stock can also be different.

In turn, this means that US equity index funds, for example,

that track different indices will differ in terms of their short-term

volatility and long-term performance. While two index funds

might have similar names, sometimes their underlying indices

may vary in terms of the investment universe they cover.

For the following illustration, we have used a real-case example

of two existing US equity index funds from well-known

providers. While both funds seem to track the US equity

market, one of them uses the S&P 500 Index, while another is

based on the FTSE World North America Index, where Canada

accounts for 5.7% of that index2. The S&P 500 Index is believed

to be one of the best representations of the US stock market

and a bellwether for the US economy. Given the indices’

geographic mismatch, there have been notable differences in

their exposures to several sectors, which in turn has impacted

performance.

As can be seen in the following chart, the financial sector

accounted for 1.25% more of the FTSE World North America

Index compared to the S&P 500 Index. The healthcare and

information technology sectors each account for around 1%

more by capitalisation within the S&P 500 Index compared to

the FTSE World North America Index. Insurance stocks are not

represented at all in the S&P 500 Index, while they account for

0.62% of the FTSE World North America Index.

As a result, the S&P 500 Index returned 111.7% over 5 years,

compared to 103.6% for the FTSE World North America Index,

and 64.3% over 3 years, compared to 59.6% for the index

provided by FTSE.

Choosing the right index

-1.00

-0.50

--

0.50

1.00

1.50

% Difference

% Difference

Consum

erD

iscretionary

Consum

erS

taples

Energy

Financials

Health C

are

Industrials

Information

Technology

Insurance

Materials

Telecomm

unication S

ervices

Utilities

0.00

20.00

40.00

60.00

80.00

100.00

120.00

YTD %Change

One Year %Change

Three Year% Change

Five Year %Change

S&P 500

FTSE World NorthAmerica

S&P 500 Index vs FTSE World North America Index:

Differences in sector exposures

S&P 500 Index vs FTSE World North America Index:

Performance

Source: Factset as at 27 February 2015 Source: Factset as at 27 February 2015

Guide to Index Tracker Funds 5

Why is there a difference in performance of an Index Fund compared to the index it tracks?Regardless of the index a tracker fund tries to replicate, there

will always be some difference between the performance of the

fund and its underlying index. In absolute terms, this is known as

‘tracking difference’, or a ‘tracking error’ if it is measured over a

period of time.

This is because all replication methods incur some dealing and

trading fees as portfolios need to be periodically rebalanced to

accurately reflect the composition of the index being tracked. The

resulting costs are deducted from fund returns.

That said, it is worth bearing in mind that larger passive fund

managers are able to achieve greater economies of scale, which

can lead to lower costs for clients. Global passive fund managers

also need to maintain and develop relationships with traders

and brokers around the world, to ensure best execution and

low trading costs. It is also in passive fund managers’ interests

to have a local presence in key global trading centres, so they

can keep up to date with changing regulations and understand

exactly how local markets work.

How is index performance replicated?There are two main methodologies used by passive investment

providers to replicate an index, with different techniques applied

to minimise tracking error.

The most straight-forward way of achieving that objective is

physical replication. In this instance an index fund manager

purchases the underlying assets of an index. We believe that

this is the best approach to take, as it allows us to construct

funds with a high degree of transparency and simplicity, without

compromising their ability to track an index closely.

When buying all of the securities in the underlying index is not

cost-effective, such as in the case of broadly-based indices such

as the MSCI World or the FTSE All Share, fund managers can use

a process known as optimisation. In this case only a proportion

of securities in the underlying index is bought.

An alternative to this is synthetic replication, whereby a fund

manager instead buys a swap from a third party, a derivative

security providing the index return from a given index in

exchange for a fee and any returns on collateral held in the fund.

Although some studies have shown that synthetic funds can

offer a lower tracking error over time than full physical replicated

funds, we believe that the risks associated with such synthetic

funds – the most important of which is counterparty risk – make

them a less attractive investment option. We also believe that

investors are not being compensated for this type of risk.

The table overleaf shows some of the main replication strategies

used in the construction of index tracker funds:

Definition Advantages Disadvantages

Full Physical Investment made in every constituent of the index proportional to its market share

` Cash flow management

` Very low tracking error

` Full transparency

` Custody costs

` Transactions costs

` Withholding tax

Optimised physical Optimisation allows the portfolio to match the basic characteristics of the index using a multi factor risk model. It is often used for broader indices

` Works well for small funds

` Efficient in liquid markets

` Lower custody costs

` Potentially higher tracking error

` Increased volatility risk

` Re-optimisation costs

Synthetic Uses derivatives (mainly stock index futures, swaps and OTC contracts) to mimic the benchmark’s performance

` Low custody costs

` Minimum transaction costs

` Low tracking error

` Swap Counterparty risk

` Non transparent

` Variable Swap Fee can affect tracking error

6 Guide to Index Tracker Funds

There are several key factors to consider when choosing the

right passive fund provider for your and your clients’ investment

needs:

` Experience

` Scale

` Index methodology

` Tracking performance / tracking error

` Costs

` Commitment to innovation

HSBC: A proven track recordGiven that tracker funds are quantitatively-driven investment

vehicles, it can be argued that they are only as good as the

processes and technology behind it, backed by knowledge and

expertise of the fund provider.

HSBC Global Asset Management is a UK pioneer in index funds,

having launched its first tracker in 1988. Since then, we have

been perfecting our investment models and developing products

in this area. Present in more than 20 countries and territories

around the world, we manage over 800 funds run by our passive

and active investment management teams.

We use our global footprint to devise cost-effective and focused

passive investment products. Our passive investment team

has full support of HSBC’s infrastructure and expertise, and

our integrated systems help to minimise client costs through

efficient execution and portfolio management.

Our focus remains on delivering highly competitive and

transparent index solutions based on robust design and high

governance standards. We believe that we are in a very strong

position to lead in passive investment in the years to come.

What should I look for in a passive fund provider?

Guide to Index Tracker Funds 7

Key Risks

Market risk:

The value of investments and any income from them can go

down as well as up, and investors may not get back the amount

originally invested.

Investment horizon:

Stockmarket investments should be viewed as a medium to long

term investment and should be held for at least five years.

Currency risk:

Where overseas investments are held, the rate of currency

exchange may cause the value of such investments to go down

as well as up.

Emerging market risk:

Investments in emerging markets are by their nature higher

risk and potentially more volatile than those inherent in some

established markets.

Geographic risk:

Some of the funds invest predominantly in one geographic area;

therefore any decline in the economy of this area may affect the

prices and value of the underlying assets.

Performance risk:

Past performance is not an indication of future returns.

Important InformationThis document is intended for Professional Clients only and should not be distributed to or relied upon by Retail Clients. The HSBC index tracking funds referred to overleaf are sub-funds of HSBC Index Tracker Investment Funds, an Open Ended Investment Company that is authorised in the UK by the Financial Conduct Authority. The Authorised Corporate Director and Investment Manager is HSBC Global Asset Management (UK) Limited. All applications are made on the basis of the HSBC Index Tracker Investment Funds prospectus, Key Investor Information Document (KIID), Supplementary Information Document (SID) and most recent annual and semi annual report, which can be obtained upon request free of charge from HSBC Global Asset Management (UK) Limited, 8, Canada Square, Canary Wharf, London, E14 5HQ, UK, or the local distributors. Investors and potential investors should read and note the risk warnings in the prospectus and relevant KIID and additionally, in the case of retail clients, the information contained in the supporting SID. The value of investments and any income from them can go down as well as up and investors may not get back the amount originally invested. Where overseas investments are held the rate of currency exchange may also cause the value of such investments to fluctuate. Stockmarket investments should be viewed as a medium to long term investment and should be held for at least five years. HSBC Global Asset Management (UK) Limited provides information to Institutions, Professional Advisers and their clients on the investment products and services of the HSBC Group. This document is approved for issue in the UK by HSBC Global Asset Management (UK) Limited who are authorised and regulated by the Financial Conduct Authority. Copyright © 2015 HSBC Global Asset Management (UK) Limited. All rights reserved. 26602CP/0315/FP15-0475 until 09/03/2016

Index disclaimers

“FTSE®” is a trade mark of the London Stock Exchange Group companies, “NAREIT®” is a trade mark of the National Association of Real Estate Investment Trusts (“NAREIT”) and “EPRA®” is a trade mark of the European Public Real Estate Association (“EPRA”) and all are used by FTSE International Limited (“FTSE”) under licence.” The FTSE 100 Index, FTSE 250 Index and FTSE All Share Index are calculated by FTSE. Neither FTSE, Euronext N. V., NAREIT nor EPRA sponsor, endorse or promote this product and are not in any way connected to it and do not accept any liability. All intellectual property rights within the index values and constituent list vest in FTSE, Euronext N.V., NAREIT and EPRA. HSBC Global Asset Management has obtained full licence from FTSE to use such intellectual property rights in the creation of this product. Standard and Poor’s 500 is a trademark of The McGraw-Hill Companies, Inc. and has been licensed for use by this Fund. The Fund is not sponsored, endorsed, sold or promoted by Standard & Poor’s and Standard & Poor’s makes no representation regarding the advisability of investing in this Fund.

ContactFor more information, please contact us:

Email: broker.sales@hsbc.com

Telephone: +44 (0) 207 024 0435

Website: www.assetmanagement.hsbc.com/passive