Long-term vision for strong links

If an old Chinese proverb says that patience and the mulberry leaf become a silk robe, the investments industry’s 60 participants, including nearly 30 Sino-foreign joint venture fund management companies, must hope that patience and the Rmb2041bn ($300bn) Chinese funds market will once again become a silk purse. Asset managers have endured a rough ride over the last 10 months with the Shanghai Composite Index which tracks the renminbi-denominated A-share market down over 50 per cent on its October 2007 peak. With performance dipping, they are struggling to both raise and retain assets from retail investors. But many have known the good times of 2006 and 2007, when a stellar stock market sucked billions of renminbi into domestic equity funds, index funds and exchange-traded funds. The first crop of offshore funds, sanctioned under a scheme which allows Chinese investors to buy foreign assets, exceeded asset-raising expectations when launched in late 2006 and last year. During that time of plenty, one of the chief concerns was how quickly China’s securities regulator would permit asset managers to launch new equity funds. In particular, those Sino-foreign JV fund management firms which set up shop in Shanghai, Shenzhen and Beijing between 2003 and 2005 had their patience and faith in the longer-term potential of the Chinese investment industry rewarded. And these same players are confident that when the markets bounce back, mutual funds will see large-scale inflows once again. Captive client base In the meantime it is difficult to elicit comment from foreign fund managers based in China on the current state of the country’s investment industry. Doubtless due to the positive image that China is keen to project to the world in the year of the Beijing Olympics, any such discussion would appear to be strictly off-limits. A spokesman for a Sino-foreign JV fund management company contacted by PWM said the securities regulator has issued a directive forbidding foreign asset managers from publicly commenting on markets. And specifically in relation to offshore funds launched under the so-called Qualified Domestic Institutional Investor scheme, he said: “Remember that it is important that the QDII products are conveyed as a significant development in the Chinese retail fund market.” Poor-performing markets are but one challenge that new and existing mutual fund players have to contend with. Gaining widespread fund distribution is an onerous challenge for many Sino-foreign JV fund managers. With their huge branch networks and captive client bases, the five big state banks – Bank of China, Industrial and Commercial Bank of China (ICBC), Bank of Communications, China Construction Bank and Agricultural Bank of China – dominate mutual fund distribution. According to Cerulli Associates, such is the power and influence of these institutions, they are able to impose onerous selection criteria on asset managers, including top quartile fund performances and significant corporate strength or parentage. In this regard, the reputation of the foreign partner in the joint venture is considered advantageous. Cerulli doubts that the role of banks in fund distribution will diminish or that other channels will come to dominate in the short to medium term. For instance, it will take a long time for securities houses to build a distribution capability that matches the sheer size of the banks’ branch networks. However, in the next three to five years, the banks’ dominance in distribution could be challenged by insurance companies if and when they set up their own asset management companies and are able to exploit their own agency networks for fund distribution. Nevertheless, research by Cerulli Associates reveals that by 2011, the banks’ share of the Chinese mutual funds market, could, at 64 per cent, be marginally higher than today. According to Denis Lefranc, CEO Asia-Pacific at Société Générale Asset Management, it is difficult to gain fund distribution through China’s large state banks without first giving them a custody mandate, even though there is no legal obligation to do so. The custody fees, he adds, are high compared with the level of fees charged in Europe and the US. The issue of custodian mandates, like falling markets, is extremely sensitive and foreign fund managers in China are reluctant to comment. Rami Hayek, managing director of Credit Suisse’s asset management business in Hong Kong, says foreign asset managers seeking to establish a joint venture in China will find that the range of established bank or securities houses with nationwide distribution capabilities have been significantly reduced over the last few years. Established in 2005, ICBC Credit Suisse, which manages more than $7bn of assets, was the first joint venture formed between a domestic Chinese commercial bank and a foreign asset manager. While smaller joint ventures are regarded as important players, he says the size of a joint venture asset management company can provide an important competitive advantage in China. Fortis Investments, the E238bn Belgo-Dutch fund house, took a major step towards growing its market share in China when in April it formed a 50:50 asset management partnership with the country’s second-biggest insurer, Ping An. The alliance would have made Fortis Investments preferred provider to Ping An’s distribution network in China and Asia. However, domestic problems for the Belgo-Dutch bank mean the plans have been terminated. RECENT QDII FUND RAISING RESULTS (RMB MILLIONS)

Problematic hurdles Until recently Fortis operated two JV fund management companies in China, one of which was formed with Shanghai-based Haitong Securities in 2003 and the other ABN Amro Teda Fund Management, which was inherited following the merger with ABN Amro Asset Management. Since Chinese law forbids the operation of two separate joint venture companies, Fortis had to put one up for sale. In late August, Old Mutual agreed to buy the 49 per cent stake that Fortis held in ABN Amro Teda. Bank of New York Mellon Asset Management, which manages assets in excess of $1100bn currently awaits regulatory approval to launch a new joint venture fund management company, following an agreement signed with Shanghai-based Western Securities last November. The new entity, to be called BNY Mellon Western Fund Management, will manage a range of equity and fixed income funds which it plans to distribute through banks, insurance companies and securities houses to retail investors. BNY Mellon owns a 49 per cent shareholding in the new joint venture, the maximum stake permitted under Chinese law. The launch of QDII mutual funds by domestic and joint venture asset management companies in mainland China is but one avenue of opportunity presented by the scheme. Foreign asset managers based outside China are allowed to provide mutual funds to bank distributors in China for sale under the banks’ QDII licences. They can also pitch for sub-advisory QDII mandates from Chinese insurance companies. Further challenges faced by Sino-foreign JV fund management companies are cultural and political. And these hurdles are proving problematic. A breakdown in communication between the Chinese and foreign partner in a JV is apparently to blame for the accelerating rate of defections of foreign-appointed general managers. According to Shanghai-based consultants, Z-Ben Advisors, conflicts can arise when the foreign and majority Chinese shareholder discuss the strategic direction of the firm. The foreign party, which is permitted a maximum 49 per cent stake in a JV fund management operation, will invariably argue in favour of developing “a solid and functional platform” to meet the longer-term objectives of the business. For its part, the Chinese shareholder will tend to focus on shorter-term goals, such as asset gathering and retention and market share, in the belief that the Chinese mutual fund market is too “fungible” to plan for the long-term. When tensions surface, senior foreign appointed executives will find themselves “stuffed between a rock and a hard place”, says Z-Ben. The struggle to resolve issues will often be complicated by the general manager’s relationship with a chairman whose role is sometimes unclear and has contributed to a number of clashes in the past. So far this year, six Sino-foreign JV fund managers have announced the departure of a foreign-appointed general manager. Consolidating power By influencing the direction of the firm from within, Z-Ben contends that most local partners in a JV have been able to consolidate power over the past five years. The report observes that in most cases, a push to appoint a general manager or CIO represented an attempt by the foreign shareholder to wrestle some control away from its Chinese counterpart. The approach allowed the Chinese shareholder to appoint the chairman, a role which is executive in nature and consequently was the basis for conflict. The lack of clarity surrounding the chairman’s role would, says the report, “have led to more than a handful of clashes on a number of issues” when the general manager found they didn’t have much in the way of real operational authority. Z-Ben says that when entering a JV, the foreign party should source candidates for the general manager role from a domestic fund manager. It should further recognise the difference between control and influence and bear in mind that there is a greater chance of achieving success “when the firm is viewed within the confines of compromise, ongoing communications and ultimately, in picking one’s battles”. Despite the difficulties faced by the foreign shareholder, Z-Ben maintains that the Chinese mutual funds market is too big to ignore as long as China fits “properly” with a foreign asset manager’s long-term regional and global strategy. David Peng, managing director of Blackrock's Beijing representative office, contends that when establishing a new JV, agreement is easily reached on mission and strategic objectives. The key objective of the Chinese partner, he says, is to learn from and emulate successful foreign fund houses in the way they manage their business. While initial hopes and expectations are shared, the reality of running a joint venture will be tested by the expectations of the domestic and foreign shareholders as well as the public, regulators and the media after business operations start. He explains: “Patience to build and grow an investment management company for the long-term may be tested by contrasting perceptions of a successful fund management company. For instance, instead of being the best fiduciary or focusing on long term business and asset gathering, the short-term competitiveness within the industry may force fund management companies to judge success on size of initial launch; fund sales based on administrative sales measures and forced bidding war to offer the highest fees to distributors. These practices will require time to work through until the clear recognition and acceptance of being the best fiduciary is the basis for measuring the quality of a fund management company.” He adds that as banks segregate custodian and fund sales business, the bank’s fund selection process will be based more on the merits of the fund management company. Similar to key bank distributors around the world, the criteria may contain fund choices, fund performance, level and quality of servicing from manufacturer to distributor. Joint ventures with banks as direct shareholders may have a better ability to arrange distribution for their JV's funds. However, Mr Peng maintains that an asset management company running funds with good consistent performance is likely to be considered by the banks.

Just a little patience With China’s long bull market run but a wistful memory, patience will be required to ride out the impact of a falling domestic stock market on both investment performance and mutual fund inflows. However, thanks to the idiosyncratic behaviour of the Chinese retail investor, things are not as bad as they could be. For despite the slump in the stock market, there is little sign of a mass exodus from domestic mutual funds. According to a report entitled “A Feat of Endurance” by Shanghai-based consultants, Z-Ben Advisors, while Chinese mutual fund industry assets dropped 20.1 per cent to Rmb2041bn ($300bn) in the second quarter of the year, retail investors held firm with index and balanced funds retaining the most assets. However, money market funds suffered significant redemptions as investors fled to the safety of bank deposits. Investors also sold out of bond funds, partly to take advantage of new bond fund offerings – an example of the “churning” which is characteristic of the Chinese retail market. Z-Ben believes that equity investors are simply biding their time, waiting for markets to rise back to the level at which they entered before cashing out of their mutual fund investments. Based upon historical trends, once share prices start to move higher, the risk of large-scale redemptions could rise. But the report adds that asset managers could benefit from the retail investor’s tendency to eschew funds which are trading well above their par values in favour of funds which are trading at or near “the magic Rmb 1 level” and which are rising fast. While JV asset management companies continue to launch new local equity and fixed income funds (with the latter attracting the most new assets in the second quarter), a sharp pick-up in interest in the QDII scheme is anticipated once markets stabilise. Of the 21 fund managers which have received licences to issue QDII mutual funds, only 10 have done so. Not surprisingly, falling markets have depressed demand for such funds. According to Z-Ben, end demand for the more recent QDII mutual funds ranged between Rmb400m and Rmb500m. An interest rate of around 4 per cent on Chinese bank deposits combined with currency appreciation estimated at 6 per cent per annum means that fund managers will have to design a QDII product which achieves an annual return of at least 10 per cent, say industry analysts. Although local fund managers are reluctant to launch offshore funds at this time, Z-Ben advises foreign fund managers to seek out a joint venture or sub-advisory relationship even if it doesn’t bear fruit right away. When conditions change, foreign firms which have partnered with local players will enjoy a competitive advantage.