The liberalisation of China’s financial markets is moving forward at a rapid pace. This will have a significant impact on the available hedge fund strategies that can be undertaken both onshore and offshore.
To date capital controls have limited access to the domestic Chinese securities markets, primarily the A-share market. However, foreign access is opening up to an unprecedented degree as more investors are given Qualified Foreign Institutional Investor (QFII) quota to invest in A-shares. This is happening at a time when China is introducing a broad range of new financial products which will pave the way for classic hedge fund strategies. The impact current developments will have on equity related fund strategies are examined below.
Domestic investors’ opportunities
At present there are really only two types of collective investment vehicles for Chinese onshore investors: mutual funds and trust funds.
The mutual fund industry is highly regulated by the Chinese Securities Regulatory Commission (CSRC) similar to the regulation of mutual funds in developed markets. However, unlike developed markets where retail investors offer relatively stable capital, retail investors in China will switch funds regularly to try invest in the best performing funds. Such performance chasing can create large flows and mutual funds in China have to deal with these flows which can go either way and are therefore often characterized by high portfolio turnover. According to industry sources, in the first half of 2012, the average portfolio turnover for the Equity Focused Mutual Funds was 220%. So despite the relatively tight regulations of the mutual fund industry, China markets behave more like emerging markets with significant volatility and wild swings in liquidity. Part of the reason for such high portfolio turnover may also be attributable to the lack of available hedging tools in China.
Trust funds are essentially private placement products for larger individual investments with longer lock-ins. Minimum investment starts at RMB1m ($160,873) with minimum holding periods which range from six months to one year. Contrast this with mutual funds where minimum investment typically starts at RMB1,000 and can be traded daily. Trust funds which focus on discretionary equity investment are referred to as “Sunshine Funds”. They are typically unconstrained absolute return long only strategies. Unlike mutual funds which are often benchmarked, the Sunshine Fund Managers will often run more concentrated portfolios. Trust companies provide the platform for trust funds to be sold. Trust companies are regulated by CSRC and there are rules governing asset security and valuation.
The managers of trust funds are not formally regulated like the mutual fund managers. The industry has started to formalise itself via the Asset Management Association of China, a self-regulated organisation, staffed by CSRC old hands, to promote a “regulated” wealth management sector. However this sector will go through a significant change after June 2013 as all Privately Offered Funds, including Sunshine Funds, will fall under the regulation of the Newly Revised Securities Investment Fund Law (the New Fund Law). This will allow private offering direct to high net worth individuals without going through a trust company. This move will result in a greater exodus of talent from the mutual fund industry to the private fund industry.
According to CSRC, as of 31 December, mutual funds NAV amounted to $567bn, investment products by commercial banks amounted to $1,220bn, trustee assets to $1,199bn, insurance assets to $1,180bn, total AUM by security companies, venture capital and private equity totaled to $560bn. Most focus has primarily been on equity related strategies, including the largest part of the trust market referred to as “Wealth Management Products”. A significant part of this category is made up of trust funds involved in direct lending; these funds are often seen as a major part of the shadow banking system. Some estimates of this market are as high as $3trn, making this one of the largest alternative investment markets in the world. Much of this lending is to sectors or industries which cannot get access to bank loans due to government measures or bank lending policies i.e. the real estate sector and SMEs. These products are readily available which results in the official loan and deposit rates being of little relevance to much of the Chinese economy.
Due to a perception there is some implicit Government guarantee#, local investors believe the effective risk free rate is 8% and not the deposit rate of around 3%. It is easy to understand how such wealth management products have crowded out other investment alternatives. Worries over the systemic risk of such products are now forcing regulators to introduce restrictions. There have also been some defaults, which at least set a precedent that there is no implicit guarantee on interest. However, as long as this market exists with some form of implicit guarantee we cannot expect a normalized investment environment.
Foreign investors’ opportunities
Foreign investors can invest in the domestic Chinese securities markets through a QFII quota facility, either directly by using its own QFII quota or indirectly by borrowing a third party’s quota. The QFII scheme was launched in 2002 with high bars to entry. As a result, QFII license were mostly granted to large global investment banks, who then lend their quota to other investors through various synthetic forms of swaps and participation notes. In the last few years, CSRC, which grants the QFII license, started to “lower” its bar, and more were approved, with a spike in allocations in 2012. It is now possible for any asset manager with AUM in excess of $500m and more than two years of operating history to apply. As of 31 December, total QFII quota granted is $37.44bn, which equates to around 1.5% of the market capitalisation of the Chinese A-share market. In January 2013, CSRC Chairman Guo Shuqing said he would like to see foreign investor quotas increased tenfold this year, which means foreign investment could potentially account for 10% of the market cap and trigger a reweighting in global benchmarks.
To date, most hedge funds have had to use investment banks’ quota. This has come at a relatively high cost, ranging between 100-150bps round-trip not including currency hedging cost, as the banks seek to maximise the degree they can monetise the quota. Hedge funds are also competing to a degree for some of the arbitrages as a bank can use their quota to exploit a premium in the ETF market by creating more units. The high cost of “access” products has reduced the viability of some of the more cost sensitive strategies. The CSRC has been reluctant to grant QFII facilities to hedge funds directly, with exceptions made for some of the longer term fundamental managers.
The QFII quota does in theory allow investment in more than just A-shares. There is also the potential to invest in bonds, open-ended funds, close-ended funds, ETFs, and warrants. However, at the point the quota is approved, it should state the intended target investments. Some banks have been reluctant to allow a high a portion of their facility to be invested outside the equity market making it harder for hedge funds to access the other products.
Growth of hedging tools
A number of domestic financial institutions now have access to a number of equity hedging tools that will start to make some of the more traditional hedge fund strategies viable. There is a future on the CSI 300 and options will soon be launched.
There is also a nascent stockloan programme. There are still some remaining obstacles for creating a new hedge fund market in China; one of these is a lack of a collective investment structure for these products so the market can only develop on a managed account basis at the moment. The second limitation is that the initial stockloan programme only allowed qualified brokers to lend out proprietary inventory, which limited the market to a few hundred million dollars.
The system has now relaxed its regulations so that institutional investors will also be able to lend their inventory of securities. This will allow the securities lending market to take off which will in turn, allow market participants to short. There will be issues which may take some time to resolve e.g. reasonable costs. Given the high turnover levels of the mutual fund industry, the stability of available securities may be compromised.
These changes i.e. enhanced regulations and hedging tools, are likely to lead to a pickup in a number of strategies. We see a clear trend of Chinese professionals who, having gained experience in the developed markets, returning home with the skills to develop local opportunities. Similarly, home grown talent has adapted rapidly to change and the knowledge base is growing at a rapid pace. For arbitrage strategies, we believe that the cheapness of the onshore convertible bond market will be exploited, along with opportunities in discounted closed end funds. We understand from many of the quant managers in the A-share market that this market has a very attractive alpha profile. This is because the stock markets are largely retail driven and full of inefficiencies. Therefore, we expect quant strategies to be popular.
As mentioned above, the development of a sophisticated long short market may be hampered due to uncertain stability of stock names available for lending; it is unlikely that the mutual fund investor community will switch from its short-term focus. However, there are a few developments which are interesting.
QFII investors have recently been granted access to the index futures contract but only to hedge their long positions. They currently do not have access to the stockloan programme, although we expect this to be opened to non-domestic investors at some point. There is however, the ability to hedge in offshore markets.
The Singapore Stock Exchange has a futures contract on the FTSE China A50 and this is becoming more liquid. Managers can also hedge by shorting ETFs listed offshore. Historically, this has been difficult as the ETFs often traded at significant premiums especially if there was a shortage of QFII facility in the market. However, the Renminbi Qualified Foreign Institutional Investor programme has allowed the Hong Kong branches of Chinese asset managers to create products for offshore retail RMB investors. This programme has seen the launch of new ETFs and ETFs now trade much closer to underlying net asset value.
With the expanded ability to hedge at an index level, we see potential growth in long short assets managed both fundamentally and quantitatively. Some of the relative value trades in cheap convertible bonds, closed end funds and relative pricing between A and H shares can be exploited to a degree on a portfolio basis. As costs come down and hedging tools proliferate, these opportunities will increase. Hedge fund managers who are not able to secure their own quota will look for opportunities to use end investors’ QFII quota and run them either on an advisory or discretionary basis. These trades can then enjoy the much lower commissions cost of local brokers, rather than pay the high commissions associated with using an investment bank’s QFII facility.
Onshore institutions are enjoying a lead over offshore institutions in terms of getting access to the new investment products. Therefore, we expect some of these strategies to be made available by onshore institutions first. It is likely that new private fund offerings of hedge fund type strategies will be made by the onshore managers alone, or with global managers acting as advisors.
A renowned global CTA manager already offers a domestic China futures CTA product by acting as an advisor to a series of managed accounts. Another investment option available to local investors is the Qualified Domestic Limited Partner programme whose pilot started in March 2012 with a quota of $5bn. This allows onshore investors to invest in global hedge fund products. However, the competing wealth management product market as mentioned above (e.g. direct lending business) might well challenge the relative attractiveness of global hedge funds in terms of returns.
The future The potential growth of wealth management products in China is expected to be high. At the end of 2011, individual deposits were just shy of $6trn, and corporate deposits were approximately $6.5trn. More significantly, in China, mutual fund assets account for less than 5% of GDP, whereas in the US, mutual fund assets account for approximately 75% of GDP. We appear to be at an inflection point in product development and market sophistication.