China catches up with the global index trend
Index-tracking investment has mushroomed in the global market in recent years. The size of the global stock market was estimated at about $36.6trn at the beginning of October 2008. After the global market recorded a -6.45% and a 3.79% growth respectively in the final two months of 2008,the aggregate market capitalisation of the stock market shrank by $1.1trn to $35.5trn. Index-tracking funds account for roughly 10%, or $3.6trn, of the total equity market. The top 49 managers in the equity market control a total asset of $2.6trn, which is more than 70% of the total index-tracking business.
In addition, the total AUM of stocks managed by the top 35 enhanced index funds amounts to $1.7trn, which is almost half of the entire index-tracking business.
In general, enhanced indexing strategies include cash enhancement, tax enhancement and methodology enhancement strategies. In particular, methodology enhancement strategies include two sub-categories, active enhancement (where the manager adjusts a few holdings in a passive index based on his expertise and market forecast) and quantitative enhancement (where the index holdings are determined by a quantitative model, also classified as strategy indexing). The latter tolerates a higher tracking error than the former. The largest enhanced index managers include Barclays Global Investors, State Street Global Advisors and Goldman Sachs Asset Management. Strategy index products by Dimensional Fund Advisor (DFA) and Research Affiliates (RA) are also considered as enhanced indices.
Since the establishment of the Shanghai Stock Exchange (SSE) in 1990, there are now around 1,700 companies publicly listed, with a combined market capitalisation of RMB20trn (roughly $3trn), making the Chinese stock market increasingly influential in the global capital market. With the rapid growth in trading volume and listings, how has the index tracking business developed? There are two primary local index providers: China Securities Index Company and Shenzhen Securities Information Company. Other global index companies or joint venture index companies also compute China A-Shares indexes. These include MSCI, Dow Jones and FTSE/Xinhua. However, they represent a small share of the Chinese domestic market.
The initiative to develop ETF products in China came from the SSE in 2001. Tremendous effort has gone into researching the market mechanisms and logistics to support ETFs. The first China A-shares ETF product, the China SSE 50 ETF, was listed for trading in February 2005. In 2006, four more ETF products were launched. Today, there are five ETF listings - E-Fund SE 100 ETF, China SME ETF, China 50 ETF, HuaAn 180 ETF and AIG-Huatai Dividend ETF. In aggregate, assets under management amount to RMB35bn, a growth of 61% a year in ETF assets since 2005. The most recent launch is the ICBC Credit Suisse Core Enterprises 50 ETF.
In addition, there are 22 equity index tracking mutual funds in China. Assets under management total RMB151bn, an annual asset growth of 74% since 2005 in index mutual funds. Combined public index fund assets stand at just over $27bn, making China the second largest index fund market in Asia after Japan, and one of the largest in the world. However, index funds standing at $3trn represent less than 1% of the Chinese equity market share, indicating significant growth of ETF assets in years to come as the Chinese investment community converges with its US and European counterparts in passive investing appetite.
The most successful Chinese index fund product has been the Harvest CSI 300, an open-ended index mutual fund. This replicates the CSI 300, the broad market aggregate index that includes the 300 largest Chinese companies listed on the Shanghai and Shenzhen stock exchanges. CSI collaborated with Harvest Fund Management to launch the fund in 2005. Today, the fund has grown to RMB31bn. There are now 27 index funds (mutual funds and ETFs) in China with an aggregate AUM of more than RMB186bn.
The Chinese market is also warming to index products outside of the traditional large-cap core areas. Both CSI and SZSI have been developing indices. They have also recently added non-capitalisation-weighted strategy indices to their rosters. Value-oriented and dividend-based indices have gained popularity with CSI and SZSI, and have been trading publicly as well as on customised bases. More recently, CSI has launched a series of Fundamental Indices (CSI/RAFI indices), headlined by the CSI/RAFI A50, in collaboration with California-based asset manager Research Affiliates. The Research Affiliates Fundamental Index strategy was awarded ‘Most Innovative New Index’ in 2005 by Index Universe. Harvest Fund Management has again taken the lead and will launch the first RAFI-based index fund in China by the end of 2009.
Today China has the third largest ETF market by assets among Asian markets, behind Japan and Hong Kong. It faces a few constraints in developing the local ETF market, as well as index tracking business in general. By comparison, the ETF and mutual fund offerings in China are still very narrowly focused on traditional large-cap equities. Also, investor participation in new index products has been lukewarm relative to that of traditional active mutual funds. This is in part driven by limited knowledge regarding indices at the retail level. This undermines market participation, and discourages product innovation. Lastly, technical challenges hamper ETF development in China. Limitations in existing settlement systems also impede the development of ETFs that invest in stocks listed on the Shanghai and Shenzhen exchanges. An ETF listed on the SSE can only invest in stocks listed on the exchange.This single-market limitation not only exacerbates the undesirable segmentation of markets but also stymies growth and innovation in the ETF market.
Index tracking is an efficient investment instrument which gives trading flexibility to both institutional and retail investors who desire low-cost passive investing. As the Chinese financial market liberalises we are starting to see progressive regulations
from the Chinese Securities Regulatory Commission to foster local market development. We expect explosive growth in Chinese index tracking business with the advent of these new developments. Furthermore, the concept of passive investing has also gained more acceptance through education provided by the index calculators and index fund asset managers. The education work should continue to improve awareness and knowledge and thereby help increase investor participation in ETFs and the index investing market.