2011 growth will be a pointer for the next decade
Aside from being the year of the Rabbit, 2011 will also be the year in which the mainland fund industry finally begins to see a modicum of stability in terms of operations. This is significant for managers who have in the past several years had to deal with (in no particular order): rapid PM turnover, diminishing demand for products, regulatory uncertainty, a global financial crisis, liquidity and inflation fears, as well as a host of other unexpected problems. While 2011 will certainly pose challenges, it will, in all likelihood, prove to be more predictable and tractable than any year since 2007. With that as the moodsetting overview, here we present our best estimates for the probable directions the fund industry will take, based on the microlevel impact of more general market conditions.
One of the most significant structural shifts that will affect the industry, regardless of prevailing market conditions, will be the existence of a sixth launch channel, as well as simultaneous product approvals. CSRC has recently appeared much more comfortable letting market forces motivate fund purchases, rather than rationing the supply of funds issued. As a result, fund managers will likely launch a steady (and increasing) number of funds, with several major impacts. QDII will also see a resurgence, though not in the way that many foreign advisors may have hoped.
Our base case calls for gradual gains in equity markets, providing support for product launches. In addition, we project that redemptions - while they will continue - will be much less severe than in previous years. In recent years, organic outflows have been such a drag on the fund industry that nearly all managers have had to rely on new product launches to grow AUM. China
AMC serves as an illustrating case study since the firm has operated under a ban on new product launches for much of the past year, whose impact is demonstrable: a 1% decrease in the firm’s market share, despite near-flawless management of dividends and other redemption mitigating work. While alternative tactics are effective, the harsh truth is that firms must launch new products to maintain market share.
Significant volatility in underlying markets, broad macroeconomic shifts, and regulatory uncertainty created a difficult environment for FMCs in China over the past three years, evidenced by the stagnation of total industry AUM since late 2007. Many firms have been reacting to momentary shifts in demand and coming late to any new product trend. Reliance on new product launches has meant even more stress on PM recruitment, and with fewer managers running more funds, performance has also suffered.
2011 will represent the best opportunity in recent memory for fund managers to put forward a strategic plan, and stick to it. While this may mean sacrificing profit margins for long-term growth, success stories in 2012 and 2013 will be those FMCs that recalibrate and take advantage of favorable equity sentiment and new regulatory policies that make it easier than ever to plan. No longer are firms constrained by potentially limiting product launch time tables. This means that firms can begin specializing and - make no mistake - many will need to do so to
remain competitive. Only firms as large as China AMC, Harvest and E-Fund can afford to be all things to all investors. Specialization will be required for smaller firms to establish a reputation within a particular product type, which will allow them to draw organic inflows and offset normal levels of redemptions. As Huashang demonstrated in 2010, this method has so far proven the only way to grow market share over a period of time.
Sacrificing profitability will likely prove a hard sell to many FMC boards. To some extent, all players in China will need to be content with reduced profit margins (approximately 30%) going forward. Levels seen in 2007 (closer to 40%) are unlikely to repeat in the near future.
Growth will mean sacrifices, especially as the industry becomes more competitive. If another explosion in equities takes place, those firms that have developed specialized business lines will be in the best position to draw inflows.
Likewise, if less pleasant scenarios are realized, offsetting redemptions with organic inflows will be the only way to maintain market share.
Fund Level Impacts
QDII funds will see a resurgence, as more firms look to round out their product portfolios. Clever product design will also allow fund managers to tap into demand, as Lion did with its QDII Gold fund, which raised an impressive Rmb3.2bn. With this in mind, we estimate that firms will bring at least 50 new QDII products to market, potentially garnering Rmb1bn each (though much of this will be taken by outliers such as Lion). Other firms will continue with traditional (Asian-equity) strategies but seek to cut costs, either by duplicating an existing QDII fund (as in ICBC Credit Suisse’s case) or utilizing an index/ETF approach.
A strong rebound in local markets (if it materializes) will likely mitigate the appeal of global stocks (even if mature markets continue recovering). As a result, strong market sentiment at home will likely hit QDII funds the hardest. While firms will continue to launch these products, they will likely raise lesser sums than local
funds in our base-case projections. Conversely, if global markets recover while domestic markets hit potholes, QDII funds may become one of the most attractive segments available.
For domestic funds, strong underlying equity growth will also mean a much more dynamic and competitive marketplace, as some small firms can now rely on organic inflows (motivated by performance) in order to grow their market share. While large firms also benefit from performance, they are more likely to face liquidity constraints in their flagship funds (and many, like China AMC, have taken to capping subscriptions in order to remain competitive).
This is also due, in part, to early market growth’s usual origin in small and mid-cap stocks. Larger firms traditionally make much of their market-share headway by investing in cyclical and large cap stocks.
In any of our projections, distribution arrangements will become increasingly important in 2011, given the large number of new products that will be launched. Small firms are able to rely on outperformance to build interest in their
products, and organic inflows are often a stable source of AUM inflows, as Huashang demonstrated in 2010. Without equity gains to support fund performance, smaller firms will be without this important recourse. Large firms, on the other hand, command sufficient power over banks to push large new offerings through the system. With limited space on bank shelves, large firms will undoubtedly edge out their smaller competitors. For small and mid-tier firms to grow their market share, equity gains will be required.
In any scenario, where equity gains come from will be extremely important, given that small- and mid-cap stocks have already reached aggressive valuation levels. There will likely be a pullback (particularly since small and mid-cap stocks are going to be more sensitive to contractionary policy from Beijing). This means that
growth will need to come from large-cap and cyclical equities. While we are confident such a change will occur, it will be difficult for many fund managers to pinpoint exactly when, particularly since many of the top-performing PMs have relied on small and mid-cap stocks to generate performance. Altering their strategies may prove to be relatively difficult, if a fundamental shift in equity direction occurs quickly. Unprepared PMs may find themselves losing out on a
golden opportunity to build their track records.
Another major shift we project in 2011 will be the growing importance of non-core business for many FMCs, particularly larger firms, such as China AMC, Harvest and Southern. While business lines such as Segregated Accounts, Multiple Client Segregated Accounts, Enterprise Annuity Accounts and NCSSF mandates are not yet the most profitable, they are beginning to represent significant portions of total firm AUM.
These segments are becoming more competitive as well, and 2011 will begin to see a “winner take- all” effect with regards to MCSAs. In the fourth quarter of 2010, it became apparent that MCSA investors were even more discriminating
than usual, in terms of funneling money to firms that were able to demonstrate outperformance. Guangfa and China Universal were two FMCs that were able to do just that, both having focused on developing their MCSA business and
Establishing (or maintaining) such a lead will require that firms have access to top-line management talent, a commodity that has been in short supply in recent years. This has less to due with the underlying quality of managers in China than it does with opportunities available, primarily in the form of private funds. Many star PMs have left their posts at public mutual funds for the more lucrative private alternative. With a record number of new product launches in 2011, this problem will be further exacerbated, and will again pose one of the biggest challenges for regulators, as previous attempts to solve the problem have been entirely fruitless, with levels of turnover remaining persistently elevated.
A Year in Transition
Since 2007, there has hardly been a period of time that can be called ‘normal’ for China’s fund management industry, yet these are exactly the years in which the industry reached maturity, and took the shape that we are all familiar with today. As a result, we expect 2011 to be more indicative of the next decade than any other period in recent memory. While many firms may have been forced to pull back on their equity exposure or launch schedules, 2011 will be a prime time to re-implement abandoned or postponed strategies. In 2009 and 2010, for example, many firms were caught off-guard by shifting product cycles. In 2011, managers will have much more control over their own fates, though this will entail securing distribution arrangements and proactively working to prevent redemptions, primarily through timely dividend payments to investors.
Our estimates suggest that 2011 will be a breakout year for several mid-tier firms, similar to Huashang’s performance in 2010. The key for these successes will be maintaining performance and retaining staff, as too often success stories
turn into routs (Bank of Communications Schroders or New China both come to mind). The first firm to solve these internal management issues will walk away with a solid slice of the market firmly in their pocket.