After China’s RMB Qualified Foreign Institutional Investors (RQFII) programme got off to a rocky start, the advent of physical ETFs under the scheme is helping to maintain interest in the investment channel while marking an important step on the renminbi’s road to internationalisation. Though the new product faces various challenges and limitations, the prospect of wider access to China continues to hold positive appeal for the investment community.

 The hefty RMB50bn ($7.85bn) expansion of the RQFII quota in April was intended to make room for a second batch of products to meet demand for higher yields and increased exposure to mainland equities. The swift expansion opened the door for physical China ETFs listed in Hong Kong, bringing much-needed diversification to the programme after a lukewarm reception for the first batch of RQFII products issued earlier in the year.

 The launch of the programme was dogged by lack of product variation and overcrowding as providers piled into the new market. Narrow allocation requirements limited equity investment under the initial RMB20bn quota to 20%, with the remaining portion restricted to fixed-income. Stefano Chao, Investment Manager at AZ Investment in Shanghai, whose parent Azimut is the manager of the largest offshore RMB fund in the world, says: “The offshore yuan market is a decent size, but possibly not big enough to absorb such a flood of investment products.”

 This time around, the roll-out has benefited from a more moderate pace. “The second generation of RQFII has been better planned, proceeding on a step-by-step basis, with the quotas handed to the larger asset managers and those that have managed to filled their initial quotas.”

 The only ETF on the market so far, China Asset Management’s CSI 300 Index ETF, had a market value of RMB3.8bn by the time it listed on July 17 - six times its synthetic equivalent, the iShares CSI 300 A-Share Index Fund. Rex Wong, Managing Director of Asset Servicing at BNY Mellon says: “Considering the size of other China-focused ETFs in the Hong Kong market, the first RQFII ETF was considered a successful launch.”

 A further three ETFs tracking other indices are in the pipeline pending approval by Hong Kong’s SFC, and are expected to launch before the end of the year - E Fund Management’s CSI 100, Harvest Global Investment’s MSCI A-shares and CSOP Asset Management’s FTSE A50. Ji Xiaoyu, an analyst with Shanghai-based Z-Ben Advisors, says: “While there were many similarities in the first batch of RQFII products and too many were issued at one time, regulators have learnt from this and want managers to issue A-Share ETFs that track different indices.”

As physical ETFs, the funds offer various advantages over their synthetic counterparts. Bypassing the need for swaps, the counterparty risk is lower, transparency is higher and the funds are not so exposed to fluctuations in value compared to the underlying basket, reducing the risk of arbitrage redemptions. The structure also potentially allows for lower management fees - the expense ratio for China Asset Management’s ETF is 99 basis points compared with 139 basis points for the iShares CSI 300.

 On the other hand, while RQFII has opened the door for direct trackers, the new ETFs are more exposed to currency risks, and may have higher issuer credit and liquidity risks. Hong Kong’s SFC issued a risk warning for China Asset Management’s funds, saying on its website: “The uncertainty and change of the laws and regulations on the mainland (including the RQFII policy and rules) may adversely impact the RQFII A-share ETFs.”

 And the RQFII channel itself is not without its limitations. The size of the ETFs is limited by the provider’s quota and is otherwise subject to an RMB5bn cap. Wong says: “In order for the RQFII ETFs to really compete with other synthetic A-share ETFs in the Hong Kong market, one of the key issues fund managers need to address with regulators is the RQFII quota that caps the size of the ETF and may affect the arbitrage and pricing of the ETF relative to its NAV.”

 Once the quota is reached, providers must go through lengthy bureaucracy to obtain an expansion, and furthermore face an operational quandary. Unable to take on new subscribers, the fund’s performance could be affected and it may start trading at a premium that adds to costs for investors.

 Regulators in Hong Kong moreover require companies issuing RQFII ETFs to have experience of the ETF industry, creating an entry barrier for some participants. On the other hand, by limiting RQFII to international arms of mainland fund managers and brokerages, mainland regulators hope to foster the development of the industry and encourage Chinese fund managers to expand into the international market.

 Lack of experience in the provider base could limit the success of the funds, and participants will need to work to build the liquidity and transparency needed to ensure tight bid offer spreads and attract large-scale investors. Jane Leung, Head of iShares Asia Pacific, says: “While the use of RQFII quota for ETFs is a positive development, I can’t say that what we’ve seen so far has been that surprising with respect to the liquidity of the new products. One of the things we have to realise is it takes a while for liquidity to build.”

 With an AUM of HK$45bn ($5.8bn), the iShares A50 is currently the largest A-share ETF, and with daily trading volumes in the $100m range, it is also the most liquid. China Asset Management’s CSI 300 Index ETF, excluding the first week it was launched, has seen an average daily volume of less than $5m, and will likely take a number of years to generate sufficient liquidity to attract large institutional investors and asset managers.

 iShares’ Leung says: “We’ve got more than a dozen participating dealers and strong client demand from various sources, institutional and retail, and you need to have that ecosystem to make a fund successful and liquid.”

Going forward, the obvious direction for RQFII is wider participation to include Hong Kong fund managers, and later Taiwanese firms. The Hong Kong Stock Exchange has recently announced the establishment of a JV with the Shanghai and Shenzhen bourses in an attempt to develop a series of new cross border indices on which a family of index products will be introduced, notes Wong of BNY Mellon: “This is a positive development to the ETF market that could leverage the RQFII investment channel recently established and could provide another broad market exposure to meet the needs of ETF investors.”

Z-Ben sees the programme continuing to develop at a rapid clip and a third round of products coming onto the market around the New Year, with actively-managed ETFs as one possibility.

With only four ETFs currently on the cards and a large chunk of April’s RMB50bn quota expansion unused, in the meantime the emergence of more passively-managed funds that offer exposure to a wider range of indices is likely. Reid Steadman, Global Head of ETF Licensing at S&P Dow Jones Indices, says: “We are hopeful that other prominent indices tracking the A-Share market, like the S&P/CITIC 300, will also be used as the foundation for new products.

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