Author: Maha Khan Phillips
In 2020, step changes in market accessibility have made direct access to the Chinese market more achievable for international investors. To realise growth potential, however, international investment managers must overcome formidable challenges, say Alastair Sewell and Li Huang
International investment managers considering expansion in China face strategic risk-reward trade-offs. Actual and potential growth, combined with materially different distribution processes and regulatory requirements, makes China as challenging as it is attractive to international investment managers. All of this is in the face of a complex and evolving geopolitical landscape.
We believe that now is the time for international investment managers to address their China strategy. In 2020, step changes in market accessibility have made direct access to the Chinese market more achievable for international investors. In our opinion, these market access changes, combined with China’s actual and potential growth, will lead to more international managers becoming active in China and to growth in the Chinese mutual fund market.
Actual Growth Is Skewed Towards MMFs
China is now the fifth-largest mutual fund market worldwide, and one of the fastest-growing. Its open-end mutual fund assets were CNY15 trillion (USD2.2 trillion) as of end-June 2020. China’s mutual fund assets grew by almost 70% over the three years to end-1Q20, while global mutual fund assets increased by just 12%, according to data from ICI Global. Assets in China’s mutual fund industry grew by a considerable 15% in 1Q20 – global mutual fund assets decreased by 13% in the same period.
This growth has not been evenly shared. Money market funds (MMFs) have been a major part of China’s mutual fund growth. MMFs need scale for success, as margins are typically low compared with other mutual fund types. In China, MMF fees are higher than in developed markets – where a typical European institutional MMF will charge around 20 basis points in management fees, a typical Chinese MMF charges 26 basis points.
This presents an opportunity for international investment managers with scale and expertise in MMFs. However, retail investors comprise around two thirds of the Chinese MMF sector, which means that those managers with more experience of retail MMF distribution may be better positioned than those with a more institutional focus. More important, however, is the potential to transition and expand assets under management (AUM) from MMFs to other asset classes.
Potential for Growth Is Significant
MMFs can serve an important market development role. They are often the first fund type to develop: their ability to use reverse repurchase agreements and buy securities at scale allows them to transform potentially infrequent government, financial institutional and corporate issuance into a smoothed maturity profile – meaning they can provide daily dealing to end-investors. From a base of MMFs, investment managers may then diversify into offering other, typically higher risk to return, mutual funds.
From this perspective China resembles a “young” mutual fund market: MMFs account for around half of Chinese mutual fund assets. In the US, MMFs account for around 20% of total assets. If China’s mutual fund distribution moves closer to international norms, there would be a significant transfer of assets to other fund types from MMFs. As other mutual fund types typically charge higher fees (for example, a typical European active equity fund charges management fees of 75 basis points), this AUM shift would also increase fee margins.
More significant, however, than this transformation effect, is the potential for new asset growth. A combination of structural factors signal growth in China’s mutual fund industry: Chinese household financial assets expanded at a five-year compound annual growth rate of 12% to end-2019 to total CNY156 trillion. In comparison, the US had just 6% growth, according to Morgan Stanley and the Board of Governors of the Federal Reserve System. Total mutual fund assets increased to around 8% of all Chinese household financial assets from around 5% in 2014, while in the US this figure is 27%, according to Wind Information. The combination of increasing wealth and higher allocation to mutual funds should boost inflows, but this could be offset by weak market performance, particularly in the context of a strongly negative global economic outlook.
China also has an ageing population, which should lift retirement savings and the need for professional pension-asset management. Citizens over the age of 60 years accounted for 18% of China’s population as of end-2018, according to China’s National Bureau of Statistics. There are, therefore, opportunities for international investment in pension asset management, particularly where large pension pools and regional investment and development pools operate insourced management models.
Challenges Are Formidable
To realise this growth potential, however, international investment managers must overcome formidable challenges.
Firstly, there is the investor base challenge: mutual funds are underused in China compared with international markets. All investment managers in China therefore must persuade retail investors to accept third-person investment management.
Secondly, international investment managers will compete with domestic investment managers for retail investment and pension fund management mandates. Domestic investment managers may have a deeper understanding of local market dynamics than international investment managers; conversely, international investment managers may have more sophisticated credit analysis, research, risk management and compliance capabilities.
International investment managers may therefore need to decide whether they buy or build local market expertise. At the same time, domestic investment managers may be impelled to enhance their risk, compliance or other processes, thus reducing any initial advantage international investment managers may have in these areas.
Lastly, and perhaps most importantly, distribution practices are materially different in China compared with in international markets. The electronic distribution channel is extremely important in China – Yu’e Bao, for a time the world’s largest MMF by a substantial margin, is almost entirely e-distributed. However, the strength of established conventional distribution networks in China may present significant access costs for international investment managers.
International Applications May Be Significant
International investment managers’ ability to access the Chinese domestic market has been limited by certain regulatory barriers. In terms of asset raising, these managers could enter only into joint ventures with domestic entities. Despite this regulatory restriction, international investment managers have been active in China: out of China’s 128 mutual-fund houses, 44 were joint ventures as of end-1Q20, and these accounted for 54% of total mutual fund assets, according to Wind Information.
The 51% regulatory cap on foreign ownership of investment firms was removed in April 2020. Since then, one international investment manager (BlackRock) has had its onshore licence approved and JPMorgan has bought out its joint venture partner, China International Fund Management. Two other international investment managers were at an advanced stage in their application for onshore mutual fund licences as of October 2020. We believe that other international investment managers will file license applications to enable them to have further access to the Chinese mutual fund market.
Li Huang is Associate Director, Fund & Asset Management, Fitch Ratings
Alastair Sewell is senior director, Fund & Asset Management, Fitch Ratings