An old man sits comfortably in one of the many drab, white-walled securities company offices in Pudong, Shanghai. He takes a sip of tea from his large thermos and scours a dog-eared stock market journal for information. He then moves to his trading terminal and enters trades. Three other old men eagerly watch their respective terminals while occasionally mumbling about their recent trades. Imagine this scene multiplied hundreds, if not thousands, of times and you get a better idea of what makes China’s financial markets tick than by reading the business section of The New York Times every day.
These retail traders are a big reason why China’s nascent mutual fund industry has been evolving in a much different way ever since the Shanghai and Shenzhen stock exchanges opened in 1990 than in, say, the U.S. or any other developed economy. Indeed, understanding China’s largely inexperienced retail investors – many of whom are betting on quick wins with short-term investments regardless of the high risks involved – sheds light on the quirks of China’s securities markets in general, and the mutual fund industry in particular.
Share and Share Alike
The growth engine of China’s financial markets has been equities. In April 2007, the Shanghai stock exchange’s market capitalization surpassed that of Hong Kong and is now approaching that of Japan. Public share ownership in China is complex, and the three classes of traded shares – A, B and H –reflect the government’s cautious approach to securities liberalization over the last 20 years. A shares are local share listings denominated in renminbi (RMB) for domestic investors, while B shares are Hong Kong or U.S. dollar-denominated shares generally owned by foreigners. H shares are for China-incorporated companies traded in HongKong. Unlike the hands-off approach of HongKong’s government, the China Securities Regulatory Commission (CSRC), the People’s Bank of China and the State Administration of Foreign Exchange closely monitor and regulate the Shanghai and Shenzhen markets.
To put the growth path that China’s markets face in perspective, assets under management (AUM) of the U.S.’s mutual fund industry is more than 65%of GDP, while in China, it is less than 10% of GDP. In the first half of 2009, the AUM in China’s mutual fund industry totaled 2.4 trillion RMB (US$351billion). Five mutual fund firms manage nearly one-third of that amount, led by local players China AMC and Bosera Funds. The third-largest company by AUM is Harvest Fund Management Co., which is 30% owned by Deutsche Asset Management and has approximately 122 billion RMB under management, or about 5% of the market. (Foreign asset management companies are allowed to operate in China under a maximum 49% ownership joint-venture structure.)
Not all foreign investors – retail or institutional –can own A shares although mutual fund investment has been liberalized slowly over recent years. Since2002, a limited amount of foreign investment in A shares has been allowed through the Qualified Foreign Institutional Investor (QFII) program. The current quota is US$30 billion. Similarly, Chinese domestic investors have been allowed to invest in foreign securities markets since 2006 through the Qualified Domestic Institutional Investor (QDII) program. This allows a limited number of institutions in China to invest in foreign assets –bonds and money market funds as of 2006, Hong Kong equities as of 2007 and U.S. equities as of 2008.
These developments, however, need to be viewed in a broader social and economic context, particularly given the dramatic changes that have occurred as the era of the “iron rice bowl” – the term referring to the job and benefits guarantees that Chinese have enjoyed – comes to an end. During the heyday of the country’s centrally planned economy in the previous century, much of the population relied on the state to provide lifelong jobs and material benefits. Although the compensation was far from luxurious, it was reliable enough for individuals not to have to worry about personal financial planning. Economic modernization has ended the paternalistic, all-encompassing state system and has paved the way for the rise of a new capitalist mindset emphasizing private savings and asset ownership.
For the first time in their lives, many Chinese are confronting the complex decisions that accompany wealth management and retirement planning. As they struggle to balance consumption and savings, choosing the correct investment vehicles has become even more challenging. And while the number of people reliant on the iron rice bowl is decreasing, the remnants of its mentality are influencing the mutual fund market, not least because the average Chinese investor doesn’t yet seethe need to seek long-term and stable returns.
Churn, Churn, Churn
The accumulation of new wealth in the absence of a widespread financial planning culture is generating several striking phenomena in the mutual fund market, says Gao, the district trading manager of Nanjing Securities in Shanghai. “There is a common tendency of investors to view the relative valuation of a fund by the absolute number of its share price,” he notes. So for example, if Fund A trades at 2 RMB, it would be considered twice as expensive and overvalued compared with Fund B, which trades 1 RMB. While the fundamental reason for this maybe the superior quality of assets in Fund A (or may even be due to the difference in the underlying shares outstanding), many mutual fund investors look only at the 2 RMB price to conclude that A is overvalued so they should sell A to buy B.
This attitude was prevalent in the recent bull market. When the price of mutual funds, which always begin trading at 1 RMB, doubled or tripled in price within a year, investors would lock in their gains by selling and then re-investing in a new fund starting at 1 RMB. As Gao notes, “This fundamental misunderstanding of mutual funds by investors in China is in part responsible for investors selling well-managed mutual funds that are increasing in value to buy more shares of a newer and lower-priced fund.”
The peculiar approach to investing combined with the remarkable increase in asset values until 2008created tremendous volatility and “churn” in mutual fund portfolios. As an article by Asia Money states, “Churning – or chao – is a major feature of the mutual fund industry [in China]…. [A] jack-rabbit investor approach means that funds have to keep 10% or more of their assets in cash to meet redemptions and so under perform [in] a bull market.” This is double the amount of cash most U.S. equity mutual funds hold in reserve. It’s the culprit behind underperformance, which was clear in data from the first quarter of 2007 amid the last extended bull market. According to Morningstar, during this period, 174 of 183 Chinese equity mutual funds – or 95% of all China-based funds –underperformed on the Shanghai-Shenzhen benchmark.
A second consequence of investors taking the absolute price as a signal of a fund’s relative value is that Chinese funds keep their share prices artificially low. Funds face a strong incentive to distribute large dividends in order to lower unit share prices and encourage investors to maintain their holdings. This, of course, means that a fund manager needs to sell stocks at a less-than-optimal time and then re-invest when prices may already be too high. Furthermore, this has negative tax implications and increased transaction costs for the fund and its investors, and can hinder a fund manager’s ability to pursue an optimal, long-term investing strategy.
Another noteworthy aspect of the Chinese market is the overwhelming popularity of new issues. Aside from the appeal of the low initial price, there is a common misperception among investors, particularly in the retail segment, that new funds are better than older ones. Many view mutual funds as being no different from common stock, a unique security that can be traded freely for short-term profit. Funds are not widely perceived as a long-term, risk-reducing investment vehicle. For this reason, the issuance of a new mutual fund often draws the same excitement as an initial public offering.
Although this is not the only factor entering investors’ decision-making, it plays a critical role in attracting retail investors to the fund. One fund set a record in 2009 by raising 24 billion RMB in the three days following its release. After all, as a Chinese proverb goes, “Prefer the new, dislike the old.”
The impact of all this would not be as significant a sit is if smaller retail investors controlled less of the market. However, institutional investment accounts for 55% of all investment in China, compared with roughly 76% in the U.S. At the same time, while institutional investors have the knowledge to act more rationally, they often cater to less-experienced retail investors. That’s opened the former to be criticized for short-termism and excessive speculation, while not paying sufficient attention to market fundamentals. A case in point is the use of equity in fixed-income funds. These funds facilitate investments of up to 20% of assets in equities, which some funds have used fully to increase their yields. In the U.S., high-yield funds rarely resort to purchasing equities, and most fixed-income funds would not think of having equity exposure for fear of losing their core investor base.
Similarly, fund managers’ incentives are structured with a big emphasis on short-term performance. That explains why monthly rankings are one of the key metrics used by investors, and a short drop of just a few months can result in significant investor redemptions. As Zhang Xingxiang, legal policy counsel for a multinational corporation in China, puts it, “If a fund manager sees the fund under his management drop for two or three months in a row, it can be a disaster. Investors typically look at these rankings, which makes the pressure for short-term success too great to develop long-term strategies.”
In more extreme cases, the success or failure of a fund’s launch might depend on its dollar amount and size. To attract the attention of an unsophisticated retail investor, who views larger funds as more prestigious and more profitable than others, a fund manager might turn to family and friends when issuing a new fund to boost its initial size. This practice is detrimental to returns because, shortly afterwards, family and friends withdraw their capital, leading to large redemptions and a lag in the fund’s performance.
Controlling the Ups and Downs
Meanwhile, the government has been very hands-on in developing mutual funds, using its regulatory power over funds to influence broader stock performance. One of the government’s key goals over the past few years has been controlling market volatility. The QFII program was set up in 2002, in part, to help increase the number of longer-term, stable institutional investors. The CSRC has been known to limit new entrants to the program if it deems that there is too much liquidity in the market.
Then, amid the growing stock market bubble in 2006 and 2007, the government opened the QDII program to allow domestic investors to invest overseas. At first, that applied only to fixed-income products (including government securities) but was expanded to certain international equity markets. The government also actively influences the market– for example, when it did not let allow any new equity funds in 2007.
In some circles, the government’s willingness to intervene in capital markets is seen as a major cause of volatility. To Western analysts accustomed to less government intervention, the market’s dramatic sensitivity to political rumor and news can be difficult to understand. However, relatively large government shareholdings in many listed companies reduce market sensitivity. From a fund management point of view, low transparency, poor implementation of securities regulations, and restrictions on hedging and risk management tools remain sore spots – as is the “heavy hand of the government,” notes a foreign investment fund executive.
Yet government regulations are limited when it comes to investor education and protection. A brokerage firm in China is not responsible for tailoring its service to the experience level of its customers. Despite serving a diverse clientele, Gao says he recommends “the same mutual fund to all my clients because I trust it.” Similarly, the simplicity of the investment account application is astounding, asking three basic questions: name, health and risk tolerance. Based on the responses, a brokerage firm will allow an investor to buy and sell any amount of any security.
More focused on managing market movements, the government has yet to wield its influence extensively to improve requirements for investor protection. As one expert notes, “The Chinese government needs to do a better job of educating investors, especially about market risks…. The lack of quality information often goes beyond bad intelligence to a failure to distinguish between basic investment categories.”
Until 2008, most investors in Chinese markets saw only consistent and large gains, which made weighing investment risk less important. In light of this, an acute sensitivity to government policy or market momentum, along with a preference for locking in short-term gains, appear far more rational than in more mature capital markets. If short-term change is the norm in China, it may be fair to ask why a long-term outlook would necessarily be beneficial.
Despite the work-in-progress nature of the mutual fund industry, the market is becoming more developed and efficient. For instance, investor education is increasing. Both regulators and the private sector are running educational seminars and programs, which can slowly lead to investment decisions that are more oriented to the long term. In addition, institutional investment is growing and is a priority for the government. China’s National Social Security Fund, with approximately US$40billion under management, is beginning to invest –although slowly – in both domestic and international securities. Likewise, many government enterprises are now providing employee pensions. These sources of institutional capital will provide a more stable and long-term-minded pool of capital. Continued growth in the QDII and QFII programs will bring further institutional capital to the Chinese markets.
The Shanghai stock exchange is also developing a global exchange-traded fund, further adding to long-term investment options. Finally, as part of a commitment to making Shanghai a global financial center, China will continue to encourage the investor community to embrace long-term horizons. Overall, despite their current quirks, China’s capital markets, specifically the mutual fund industry, appear headed in a promising – and profitable – direction.