Citi OpenInvestor SM The Game Changer for Hong Kong Insights Institutional Investors
2 Citi OpenInvestor SM The Game Changer for Hong Kong Stewart Aldcroft Senior Advisor, Investor Services, Asia Pacific Securities and Fund Services On January 23, 2013, at a small gathering of securities industry types, Alexa Lam of the Hong Kong Securities & Futures Commission (SFC) announced that the SFC and the China Securities Regulatory Commission (CSRC), were in negotiations for the mutual recognition of mutual funds and unit trusts from each others jurisdictions, to be allowed to be sold to retail investors in each other s markets at some time in the future. This initiative could be regarded as one of the most significant developments for the Hong Kong fund management industry in a generation. It is the potential game changer that Hong Kong has been waiting for since China began to open up its markets. What it does Of the 2,200 plus SFC-authorized funds in early 2013, around 10% or approximately 200 funds would currently qualify for this recognition scheme. As a result, many global fund management businesses have begun to create local fund platforms, where previously they had relied exclusively on their UCITS products. in theory, is to enable access to a market of potential investors that is more than 100 times larger than the current size of Hong Kong. While the final details of this recognition have yet to be finalized and could well be subject to significant influence and change as they are worked on by both sets of regulators, there is no doubt that a great opportunity exists for fund companies to access the China Mainland market for the first time, without the need to establish a joint venture fund management company. What is known at this stage is that for Hong Kong, the mutual recognition will only be applicable to those funds that are domiciled and SFC-authorized in Hong Kong. That means that UCITS products from Luxembourg and Dublin are excluded. Domiciled in Hong Kong is taken to mean that only those funds set up by a Hong Kong licenced fund management business, using a Hong Kong Trustee and in effect, having its primary place of business in Hong Kong, will qualify. The SFC authorization of a fund does not restrict management of the assets to only be carried out in Hong Kong, indeed, their guidelines also allow Hong Kong authorized funds to be set up as fund-of-fund types as well.
The Game Changer for Hong Kong 3 This certainly may allow greater flexibility when considering ways forward as is discussed below. Of the 2,200 plus SFC-authorized funds in early 2013, around 10% or approximately 200 funds would currently qualify for this recognition scheme. As a result, many global fund management businesses have begun to create local fund platforms, where previously they had relied exclusively on their UCITS products. Why is China such a Big Opportunity? Consider Some of the Facts. Since the start of the mutual fund industry in China less than 15 years ago, total assets in funds, trust company products and insurance savings vehicles have grown to exceed USD2 trillion in size 1 The domestic market is dominated by local players offering local funds that only invest in China-listed securities. There are 80 fund management companies offering around 1,100 CSRC-authorized fund choices 2. Approximately 220 million people in China have to date invested into a mutual fund 3. Trust company products, which have greater flexibility in their investment choices, have become more successful than mutual funds The current market capitalization of the securities listed in China exceeds USD4 trillion. There are more than 2,500 listed securities 4 The average savings rate in China exceeds 50% of GDP. It is reported that the savings rate exceeds USD4 trillion per annum 5 Fund distribution in China is dominated by the big five banks, who control approximately 90% of the assets raised to date 6. These banks have more than two million branches around China, enabling local access 7 Typically, investment returns from local Chinese funds have been relatively poor, due in part to the poor performance of local stock markets Mandatory Provident Fund (MPF) use in Hong Kong Under current MPFA regulations, any fund that wishes to be used for the MPF in Hong Kong is required to be set up and also domiciled in Hong Kong. Approved Pooled Investment Funds (APIF) is the term generally used to describe these products. Most of the 450 APIFs set up to date, in some way replicate other funds in the product range of their issuer, i.e. fund manager or sponsoring manager of the MPF product. However, a common complaint of these fund companies has been that apart from use within the MPF, there is little opportunity to distribute these products in the local market as standalone funds. The MPF is now a USD55 billion pool of assets that is forecast to grow rapidly in the next few years. Nevertheless, participation in the MPF has been limited to only a few fund houses, those that were able to set up from day one, or who have the strongest connections with the 20 providers of MPF products in the market. By being able to offer local RMB-denominated funds to MPF providers, this will enable a wider choice of funds to be offered to MPF members, and give access to the MPF market for many fund companies for the first time. It should be remembered that APIFs are stand-alone MPFonly products, regulated by the MPFA not the SFC. Thus they are not eligible for this crossborder recognition scheme. By being able to offer local RMB-denominated funds to MPF providers, this will enable a wider choice of funds to be offered to MPF members, and give access to the MPF market for many fund companies for the first time. But getting access to the China market is not the only benefit to be gained from this initiative. There are a number of others which should not be overlooked. 1 Insurance Savings Vehicles: 2012 China Statistics Book 2 China Securities Regulatory Commission, List of Securities Investment Funds, March 2013 3 Asset Management Association of China, Industry Update, June 12, 2012 4 China Securities Regulatory Commission, Securities Market Statistics in February 2013 5 China, India: Meet the Economic Giants of Tomorrow, Financial Post, November 9, 2012 6 Custodian Fee Reduced to $4.87 Billion Last Year, Finance China, April 15, 2013 7 China Banking Association 2011 China Banking CSR Report
4 Citi OpenInvestor SM By setting up a Hong Kong local fund, there is no longer any need to take account of the myriad of European regulatory issues and frequent changes. Recent among these have been the Financial Transactions Tax, MiFID, salary and bonus caps. Lower Costs = Lower TER A key concern of all those involved in the fund management industry has been about how costs have escalated in recent years. Costs are made up of a number of factors, including management fees, marketing and administration, sales distribution, custodian and trustee, accounting and transfer agency. Add to these the legal expenses, not just at the time of set up but also on-going, the total becomes quite impressive. Typically, Total Expense Ratios (TER) have been running at up to 3.5% on many funds regardless of size. Indeed, a number of commentators have questioned why it appears as if no account has been taken for size of assets. It can be expected that in creating local funds in Hong Kong, the aggregate of costs incurred will be far lower than if the same fund were set up in, say, Luxembourg. European Regulatory Changes As all those that offer UCITS products from Luxembourg or Dublin are aware, European Union changes to their funds regulations have been increasing in recent years. We are already working on UCITS VI despite UCITS V not having been finalized. Then there is AIFMD, MiFID II, RDR, and a raft of other changes that, while applicable to the European markets, may have little relevance in Asia. Each time any significant change occurs, it is necessary for the legal advisers to the funds affected to consider whether this needs to be approved by the SFC in addition to it passing through the home base regulators. In recent years, there has begun to be some concern expressed, especially by regulators in Asia, that the extent of change to the European regulatory environment has become too great, too fast, and not reflective of the needs of those in Asia. With the lower returns being achieved on investments, and in particular the emphasis on bond and fixed income in recent years, concerns have centered on the ratio of return to TER. In many instances, this has become a negative ratio, i.e. the TER exceeds the average return of the fund over a three or five-year period. Clearly, from an investor level, this is unacceptable, hence a lack of enthusiasm to buy high fee charging funds. It can be expected that in creating local funds in Hong Kong, the aggregate of costs incurred will be far lower than if the same fund were set up in, say, Luxembourg. Use of Derivatives Following the global financial crisis in 2007-08, many regulators expressed concern about the extensive use of derivatives in funds. While in hedge and alternative funds this is regarded as acceptable, given the nature of these vehicles, it should be expected they will use derivatives. But traditional funds have increasingly been seeking to add the use of derivatives in the normal course of managing underlying assets. Regulators have believed that where derivatives are used for efficient portfolio management this can usually be acceptable, albeit, it will need to be clearly documented and approved. However, there are many fund managers that as a matter of course, seek to use derivatives in the daily management of assets, to enhance
The Game Changer for Hong Kong 5 positions in certain stocks, and to hedge against market reversal. Again, nothing wrong with this if correctly documented, but it has become evident that by including use of derivatives in the investment objectives, the approval time for a new fund to be set up can be greatly extended, often but as much as six months, in Hong Kong. It is similar in Singapore. On the converse, by not including the use of derivatives in a fund, the time to achieve authorization in Hong Kong can be greatly reduced, thus achieving a speedto-market for new funds. Will Hong Kong/China Recognition Include Taiwan? Initially it is unlikely that Taiwan will be included in the mutual recognition scheme. This is clearly because it is a development coordinated between the SFC and the CSRC. As Hong Kong is now a part of China, it is very natural for the Central Government in China to want to make its first international developments via Hong Kong, which is a place it knows and understands far better than any other market. Subject to how the mutual recognition scheme develops, it is quite possible that Taiwan will be included at a later date, although the timing of this might be a year or two away. How will this Impact Fund Distribution in Hong Kong? Distribution of mutual funds and unit trusts in Hong Kong, as in China, is dominated by the major banks. According to a recent survey by Cerulli, banks still represent more than 65% of fund sales. Insurance companies, wealth managers, and independent financial advisers (IFA) make up the rest. Traditionally, banks have adopted an open architecture approach when identifying both the funds and fund companies they wish to offer their customers. This has worked well, to broaden the choice available to local investors, but it can be argued, usually by smaller and newer fund companies, that it is extremely difficult for them to enter the market, as bank distributors (especially) are reluctant to add new products and managers to their platforms. What has not been available to Hong Kong investors, has been a choice of funds that invest directly into China s A Shares, listed in Shanghai. Although there are a variety of alternative products, including Exchange Traded Funds (ETF), until recently, for an investor wanting access to China it was necessary to select from either an H Share fund, i.e. investing in Hong Kong listed China companies, or use one of the ETFs that provided a synthetic access. This changes with the mutual recognition scheme, as quite obviously Hong Kong will open up to the broad range of China funds on the Mainland. Of course, most people in Hong Kong will not be familiar with the names or the products being offered, and thus will need to rely on their advisers for this information. Advisers will need to be able to get accurate information on the returns achieved, portfolios, and thus make informed decisions on preferred products. Until now, not much of this type of information has been made available outside China on these domestic funds. Performance ranking, volatility numbers and other similar measurements will need to be carried out, and then compared to what else might be available with a similar investment objective. It seems unlikely, however, that China funds will be popular with Hong Kong domestic investors until such time as the stocks in China start to achieve consistent and positive returns. It should be remembered that the Chinese stock markets have been among the worst performers in recent years, a position that needs to be reversed before much money starts chasing the performance. By not including the use of derivatives in a fund, the time to achieve authorization in Hong Kong can be greatly reduced, thus achieving a speed-to-market for new funds. Multiple Share Classes, RMB and Dollars An obvious conclusion of the mutual recognition scheme is the need for Hong Kong funds offered into China to be denominated in renminbi (RMB). To date, the SFC has not authorized RMB funds for retail distribution in Hong Kong, usually on the basis of there still being an illiquid market for RMB. This argument can no longer hold true, and indeed the sheer size and scale of RMB trading in Hong Kong is such that it is clearly now a liquid currency. Thus new local funds, and existing funds wanting to access China s retail markets, will need to be RMB-denominated. This may well prove to be attractive also to local Hong Kong investors.
6 Citi OpenInvestor SM What Funds are Asian/Chinese Investors Interested In? Of fundamental importance to the global fund companies wishing to offer their products in China, is going to be identifying which products, which investment markets and styles, which sectors, will be of interest to the typical Chinese investor. Clearly Chinese investors have already had offered to them a choice of all the different styles and types of Chinese equity or fixed income funds they could possibly want. Clearly Chinese investors have already had offered to them a choice of all the different styles and types of Chinese equity or fixed income funds they could possibly want. It would be an exceptionally confident manager that thought of entering the China market with anything similar to what is already out there in the market today. On the other hand, asset classes that are not available to Chinese investors, such as international stocks, market sectors, etc., could prove just as problematic, given the rather negative experience had by those that tried the QDII international investing scheme in China in 2007-08. A lasting and negative legacy was created by launching the QDII at the top of the market. Only a few investors have seen a positive return on their money to date, although in fact they would have done better than if investing into China stocks over the same period. Themes, such as Global Brands, Luxury Brands, Power and Energy, Infrastructure, Electronics, which are relatively familiar to the average Chinese consumer, might achieve some About Hong Kong/China Mutual Funds Recognition What we do know What we don t know What needs to be known Bilateral agreement between China and Hong Kong, no changes to existing Rules Does not involve Taiwan, Singapore or anywhere else Hong Kong domiciled, SFC-authorized funds China CSRC approved funds for China No UCITS, Cayman or other funds CSRC and SFC are in early stage of discussions SFC Funds Authorization Codeallows a wide variety of fund types Technical study groups meeting in Beijing and Hong Kong, regularly Purpose is to facilitate cross-border fund distribution between Hong Kong and China Of the 2,000 plus SFC-authorized funds, only around 200 currently qualify Will it be a pilot scheme with only a few initial participants Will there be restrictions based on AUM, size of fund, age of the fund management company, etc. Are ETFs included and how What restrictions on use of derivatives will be placed How will Mainland funds be allowed into Hong Kong? Will the SFC impose restrictions Will hedge funds and alternative investment funds be allowed Can Fund of Funds products, managed in Hong Kong, be allowed to invest in UCITS Will this lead to an Asian Funds Passport or just a Greater China Funds Passport As China does not have Trust Laws, and only unit trusts can currently be domiciled in Hong Kong, how will this work Will this replace QDII Timing, will there be advanced notice Any secondary approval process in HK and China Who will be allowed to distribute How to gain support from key market distributors What fund types, markets, products will be attractive to Mainland investors Will RMB Share classes be allowed for these and all other SFC funds When will OEICs (i.e. mutual funds) be allowed Will the SFC allow new fund applications on spec in parallel with these new recognition developments Will Chinese fund management companies in Hong Kong get priority on processing of products Is it necessary to set up offices in both Hong Kong and China
The Game Changer for Hong Kong 7 resonance. Or maybe global or regional themes that can relate better to the way Chinese politics are evolving, could have some impact, thus funds targeting selected countries such as Australia (for the resources) or Africa (where China is a major investor) could prove popular. Undoubtedly this will not be an easy task, especially given the market understanding that Chinese banks aim to maximize their commission revenues from fund sales by retaining as much as possible of the fees charged by funds, both initially and in on-going management. Distribution Issues As discussed above, in China, fund distribution is dominated by the big four retail banking giants. It is estimated that they represent around 90% of fund sales currently. However it is also perceived that this dominance is weakening through the introduction of insurance companies being allowed to create their own mutual funds, allowing their in-house sales forces to sell these products to customers. There are also signs that a few independent financial advisory firms are beginning to set up, and they too will be interested in not offering what their banking competitors offer to clients. For the global fund managers trying to enter the China market, they are going to face the challenge of negotiating distribution agreements with outlets used to dominating this landscape. Conclusion The mutual recognition scheme to allow distribution of mutual funds and unit trusts domiciled in Hong Kong and China into each other s markets is clearly a game changer for the growth of the Hong Kong fund management industry. Handled correctly, it has the potential of turning Hong Kong into the dominant locale for the establishment of funds in the Asia Pacific region. For the global fund managers trying to enter the China market, they are going to face the challenge of negotiating distribution agreements with outlets used to dominating this landscape.
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