On October 1, following high-level discussions earlier in the year at the U.S.-China summit in Washington, Beijing opened the way for foreign banks and other third parties to sell local mutual funds to Chinese investors. Although little noticed outside the asset-management industry, experts say the step is a key element in Beijing’s broader strategy to expand its capital markets and simultaneously improve the flow of capital to Chinese enterprises.
Industry players, in fact, say the new rules from the China Securities Regulatory Commission have already begun to change the playing field. For instance, a new PwC survey of foreign fund management companies in China found a growing sense of optimism among companies and expectations for a significant step-up in their business over the next three years. As a result, foreign fund managers in China are moving quickly to introduce new funds, with more than 112 funds in 2011 alone.
In addition to the regulatory changes, several powerful trends are combining to fuel the industry’s growth. These include the continued strength of the overall economy in China, Beijing’s efforts to ‘internationalize’ its currency, and intensifying investor interest in renminbi-denominated and China-related investment products. Nonetheless, experts also expect the changes in China’s asset-management industry to play out over a period of years, and note that major operational challenges remain for foreign players and other new entrants, which will take time to overcome.
“China is potentially the world’s most lucrative market for asset managers, and new regulations have relaxed controls over new product launches,” reported EmergingSignals: China, a research service, this month. “Following two years of stagnation while markets recovered from the 2008 downturn, recent forecasts project that the industry will triple in size to $1.1 trillion in assets under management by 2015. However, recent surveys also indicate foreign managers are losing market share in the face of competition from their Chinese competitors.”
At present, more than 30 foreign fund-management groups operate in China, through minority positions in joint ventures with prominent Chinese groups. These include, for instance, Blackrock with Bank of China, J.P. Morgan with China International, Generali with Guotai, Deutsche Bank with Harvest, and Rothschild with Zhonghai. While the foreign joint ventures outnumber purely domestic asset-management groups, experts say Chinese firms were able to stake out market positions before the recent regulatory changes and at this point still account for eight of the top 10 groups as measured by assets under management.
Increasing competition, though, has had an impact on profits. A recent report from financial market researcher Cerulli found that although the overall business is still profitable, the industry’s margins have been declining. For instance, one key indicator, net revenue yield, which is the amount in basis points that fund managers receive for each dollar of assets under management, dropped from 108.6 basis points in 2008 to 42.3 basis points in the first half of 2011.
The pressure on margins, experts say, has made it even more important for companies to increase assets under management as rapidly and substantially as possible. According to one local fund manager, fund companies on average now need at least 10 billion renminbi under management in order to break-even, up from 7 billion renminbi just recently, making it extremely difficult for new funds to survive.
Assets Under Management
Over the last two years, assets under management for the total sector in China have fluctuated but have not made much headway, according to Z-Ben Advisors, a consulting firm. In the second quarter of 2009 total AUM were 2.30 billion renminbi, and by the end of the first quarter 2011 they were up just slightly to 2.39 billion renminbi — and down from a high of 2.68 billion renminbi in the fourth quarter of 2009.
Nonetheless, Alex Wong, Alex Wong, a partner and the asset management industry lead for PwC China in Shanghai, says assets under management, as a result of the tough business environment, will remain the benchmark measure of success. “The challenge right now, however, is that the general public is not really that insightful about investing. Many are interested more in speculative trades than long-term value. So the general environment is not really favorable for fund companies in China right now – this is the primary challenge and we see it largely the same in the near term.”
Indeed, the idea of small-time individual fund investors in China is largely a myth, experts say. Instead, the market is dominated by big-time speculators with access to money-market funding. For example, although China now has more than 120 million registered stock-market trading accounts, and almost all are in the name of individuals, industry analysts say that at least half of those accounts reflect the fact that investors must open two separate accounts to trade in the Shanghai and the Shenzhen markets. At most, experts say, China may have 10 million to 20 million active retail investors – and some say the real number may be even lower.
Another major challenge facing fund companies in China is distribution.
According to industry reports, China’s four largest banks account currently for more than 60% of mutual fund sales (in terms of net asset value). And even in the short-term, China’s domestic banks are expected to continue to dominate the market, thanks to their extensive branch networks, an enormous structural advantage in China.
“In reality, this is low-hanging fruit for the banks,” says Stephanie Woo, an analyst at GaveKal Research. “Their well-established distribution networks and close relationships with customers make cross-selling easy. At the same time, consumers are not yet very savvy about different types of financial products, so they tend to rely on the banks a great deal.”
Meanwhile, responding to the increasing demand, Woo says China’s large banks have become more and more aggressive in their 'channel maintenance fee', the commission charged to funds. “They have begun to charge new fund houses up to 60% of a fund's management fee as commission (for existing funds, the agreed rate in the past was 30%). Given on average a management fee of 1.5% to 2% charged by funds, minus the channel maintenance fee by banks, this gives the funds a net charge of only 0.6% to 0.8%, not yet including other costs they have to incur.”
Nonetheless, experts predict that over the next two to three years a much broader distribution network will emerge, as the market opens up. For instance, until recently, third-party firms were almost non-existent in China because of banks' dominance in the sales channel, but the new rules appear to relax the entry qualifications for institutions selling fund products. Experts now say this opening will encourage more third party firms to enter the industry in 2012.
In addition, as part of that new trend, entirely new services, products, and partnerships are likely to emerge in China over the next few years — especially from foreign players. “It would take decades to build up the kind of distribution networks that are currently dominated by the ‘Big Four’ banks,” one industry insider told the Financial Times earlier this year. “So foreign banks are likely to attack this from a different angle, because it is impossible for them to compete in terms of scale.”
“Foreign banks have not really put up big numbers yet,” says PwC’s Wong. “In terms of distribution coverage, a foreign bank cannot really help… but in terms of synergies there can be real benefits. For example, with the new regulations in place, they can team up to launch products that are more tailored to different market segments.”
Indeed, in recent months, foreign firms and some of China’s new financial players have been quietly but consistently increasing their investments in the fund sector. One of the world’s largest private equity firms, San Francisco-based TPG, announced earlier in the year that it would join with the Shanghai and Chongqing municipal governments, two of China’s largest cities, to raise nearly $1.5 billion and create its first funds denominated entirely in renminbi. Analysts said the TPG deal – along with other ventures by Blackstone and Carlyle Group – represented a significant push to raise renminbi-denominated funds targeted at what they expect to be a growing pool of wealth in China.
In addition, foreign management companies have accelerated their new fund launches over the last two years, according to PwC’s report. The opening was made possible in part by an revamped approval process as well as the ability introduce two new funds a year within each of five different channels: qualified domestic institutional investor (QDII), fixed income, active equity, passive equity and new or innovative products.
“The continuing growth in diversity of product and the introduction of cross-border activity are important recent developments in the internationalization of the funds industry in China,” PwC found. “There is still a long way to go, but it is this huge upside potential in the industry that will draw a significant number of new foreign participants into the marketplace.”
To be sure, regulation remains the biggest driver of change in the industry, and China’s evolving investment environment continues to present a series of obstacles to foreign corporations hoping to profit from the country’s growth in key sectors such as banking and financial services. In August, the newly-arrived U.S. ambassador in Beijing said such barriers called into question whether foreign investors are truly welcome in China, and the EU trade commissioner recently complained that important sectors in China remain closed or restricted to European investors.
Still, EmergingSignals: China recently reported that Chinese leaders continue to regard the participation of foreign-invested businesses as an essential element in their long-held strategy of integrating the Chinese economy into global networks of investment, production and trade. And as the transition to a new generation of top leaders gets underway in 2012, many analysts believe that Beijing will therefore be careful to avoid steps that could damage international confidence in China.
The bottom line, market watchers note, is that Chinese leaders appear increasingly receptive to developments they believe will strengthen China’s financial services industry and help advance plans for transforming Shanghai, in particular, into a global financial center. The recent moves in the fund market, they say, are a small but important step in that direction – and one that immediately intensifies the competitive dynamics in the industry.