China's first open-end stock fund could lead to a thriving equity culture and a booming fund market - provided the country's fickle investors go along.
By Kevin Hamlin
October 2001
Institutional Investor Magazine
Few portfolio managers have quite as much riding on their performance over the next couple of quarters as Han Fanghe.
Han's Huaan Fund Management Co. was chosen by the China Securities Regulatory Commission to launch China's first-ever open-end mutual fund this September. If the Huaan Innovation Fund posts reasonably good numbers this quarter and next and retains most of its 5 billion yuan ($609 million) in assets, the CSRC is expected to open the door to other fund launches - creating a potentially vast market among China's hundreds of millions of savers. "This is a historic opportunity," declares the soft-spoken but supremely self-assured Han. "For the next three to five years, there will be explosive growth in China's asset management business."
But if Han stumbles, the CSRC, China's securities watchdog, will likely delay the licensing of other funds, putting a considerable damper on development of this potentially multibillion-dollar market.
China's 13 other asset management firms, ordinarily determined rivals of Huaan, are pulling hard for Han to succeed. They'd dearly love to get a crack themselves at the estimated 6.7 trillion yuan that China's diligent savers have socked away in bank deposits as well as tap into a fledgling pension market that's projected to grow by leaps and bounds.
Also rooting for Han are large foreign firms - such as Deutsche Asset Management, HSBC Asset Management, Invesco Asset Management and J.P. Morgan Fleming Asset Management - that have signed technical-assistance agreements with local firms and hope in time to buy chunks of them. China's imminent entry into the World Trade Organization, expected late this year or early next, will allow the global fund giants to purchase minority stakes in Chinese money managers like Huaan. A popular new product, such as open-end funds, can only increase the allure of these businesses.
Beijing, too, will be keeping a wary but hopeful eye on Han's progress. The CSRC not only selected Huaan for its test case but also had a hand in designing the fund. The government wants to stabilize its volatile, retail-investor-driven markets in Shanghai and Shenzhen. And it sees a robust mutual-fund business run by professional managers with long-term investment horizons as a crucial step toward creating liquid markets to help underwrite China's development program and pension scheme.
Early signs have been encouraging. Demand for the Innovation fund, which invests in A shares - those available only to Chinese nationals and listed on the Shanghai and Shenzhen exchanges - was robust in September. Investors in 13 cities queued for hours at the 139 branches of Bank of Communications, Huaan's main distributor. Han received almost 6 billion yuan of orders but capped the fund at 5 billion yuan because he didn't think he could manage more money without undermining his performance.
An affable, low-key sort, Han, 50, would seem to have just the right blend of diplomatic and financial skills to be China's mutual fund pioneer. As a director of the Shanghai Price Bureau, he helped deregulate price controls on everything from basic commodities to dance hall admission charges in the mid-1980s and early 1990s. Letting market forces set prices while keeping inflation in check required a deft political touch to stave off social unrest.
But Han also happens to be an experienced fund manager. In the late '90s, as the general manager of Shanghai International Trust & Investment Corp.'s securities division, he launched an industrial investment fund to make direct investments in Chinese companies and managed to raise money from Goldman Sachs Group and Merrill Lynch & Co. as well as the International Monetary Fund. During three years at the helm, he produced a 10 percent annual return.
Still, Han must contend with one crucial constituency that is even more difficult and unpredictable than Beijing bureaucrats: Chinese investors. Yes, they rushed en masse to participate in the Innovation Fund, but they're also prone to head for the exits at the first sign of trouble. And producing consistent gains in China's roller-coaster markets is no small feat. This year Shanghai's and Shenzhen's B-share markets, reserved for foreign investors until August, rose more than 150 percent and 200 percent, respectively, between February and June, only to give up more than half of their gains through mid-September. Market capitalization in the B markets tripled to $21 billion in the year's first half, then fell back to $13 billion over the next three months.
The rapid-fire trading of China's 40 million to 50 million individual investors accentuates market gyrations. Even the portfolio managers at China's 35 closed-end funds can't seem to resist darting in and out of stocks. Average portfolio turnover in 2000 exceeded 100 percent and in one case reached 867 percent.
Some feel this penchant for ultra-active trading portends trouble for flexible open-end funds, which let investors buy or sell at any time. "At the beginning the public will be very interested in open-end funds, but in a few months, Huaan may face huge redemptions. That is the big challenge," says Cary Zhang, chief marketing strategist for Fullgoal Fund Management Co., which intends to offer its own open-end fund. (Zhang is one of several Chinese-born Americans who've returned to their homeland, bringing Western financial expertise with them: see story below.)
Even some of Han's business associates fear that investors' enthusiasm could sour quickly. Gu Nasha, assistant general manager for fund custody at Bank of Communications, the country's fifth-biggest bank, contends that the eager initial response was based on "a very strange Chinese custom and perhaps an irrational one: that people always think the first is best." Might redemptions follow soon? "We think it's possible," acknowledges Gu. "I can't imagine if the fund loses money and customers come to ask for their money back." Of course, the bank won't refund their cash.
The CSRC's commitment to open-end funds is not capricious. As Stuart Leckie, chairman of consulting firm Woodrow Milliman China in Hong Kong, points out, "China is just absolutely fixated on institutionalizing its markets" to purge the speculative mentality. CSRC senior adviser Anthony Neoh says funds like Han's are designed "to ensure that the capital markets get a group of investors who pay attention to the quality of information disclosure and corporate governance." The government, whose progress toward financial reform has been erratic, has taken bold steps to make certain that the fund thrives, even seeking advice from Western asset managers and allowing Han to sell the fund through a respected bank.
But then, the Chinese have a lot riding on the creation of large and liquid markets. Hong Kong brokerage firm BNP Paribas Peregrine projects that to meet its development goals, China will need 20 trillion yuan in capital from 2001 to 2005 and a further 30 trillion yuan from 2006 to 2010. Moreover, Beijing, which provided no pension system until recently, must reckon with an aging population: The number of Chinese over 65 totaled 76 million in 1995 and is expected to reach 300 million by 2050.
Fund managers also have a great deal riding on China's ability to foster large and stable capital markets. Right now the majority of the country's 22.6 trillion yuan in savings - the 6.7 trillion yuan from households along with 5.45 trillion yuan from companies - is tucked away in bank deposits paying just 2 percent or so, according to Peregrine. About half of the remainder - 4.77 trillion yuan - is invested in the stock market. The rest is divided among Treasury bills, corporate bonds, foreign exchange deposits, cash equivalents, insurance policies and closed-end funds.
China's pension assets, meanwhile, could grow explosively over the next quarter century as the country seeks to provide for its 1.3 billion citizens. China's patchwork pension system could rocket from $15 billion to $1.8 trillion by 2030 if Beijing follows through on planned reforms, according to World Bank and private estimates. Hong Kong's state pension scheme, the year-old Mandatory Provident Fund, is expected to grow at less than half that rate.
Asset managers see large opportunities for handling the bigger pension accounts as well as investments for wealthy individuals. "China's asset management industry will dwarf Hong Kong's, and it will catch Taiwan's and South Korea's very quickly," predicts Mark Konyn, head of Asian marketing at Dresdner RCM Global Investors Asia in Hong Kong. Adds Yan Xiaoqing, chief representative for Fortis Investment Management in Shanghai, "No global fund player can afford to ignore this market." Peregrine projects that funds under management will rise from 90 billion yuan currently to 120 billion yuan just by the end of next year and to 250 billion yuan by the end of 2005. Consultant Leckie notes that the common market-penetration rate for funds in Asia of 8 percent would translate into 100 million accounts in China. "That's enough to make people excited," he says.
The government's three-year-old push to allow foreign firms to participate in this making of a market has set off a whirl of mating dances. Among the leading foreign firms to pair off with locals: Deutsche Asset Management with Da Cheng Fund Management Co.; HSBC Asset Management Hong Kong with China Southern Fund Management Co.; Invesco Asset Management with Penghua Fund Management Co.; J.P. Morgan Fleming Asset Management with Han's Huaan and UBS Asset Management with China Guotai Fund Management Co. Huaan and J.P. Morgan took their relationship a step further in July when they agreed to form a joint venture in which J.P. Morgan Fleming Asset Management would hold a 33 percent stake once China joins the WTO.
Other foreign firms have chosen instead to forge ties with Chinese securities houses, many of which have good retail distribution through extensive branch networks. Securities firms are expected to obtain licenses to run open-end funds over the next year or two. BNP Paribas Asset Management has teamed up with Shenyin & Wanguo Securities Co., Fortis Investment Management is linking up with Haitong Securities Co., and Schroder Investment Management is joining with China Galaxy Securities Co., China's top brokerage house.
The CSRC's Neoh does little to temper the foreigners' exuberance. "If the state were to adopt an American ERISA tax-incentive approach [to retirement plans] and mutual funds became qualifying investments, the industry would burgeon," he says. The State Council, China's highest policymaking body, is looking into tax deferrals for retirement accounts.
Nevertheless, the government has a long way to go in pension reform. Under the current system, state-owned enterprises organize their own retirement plans while large portions of the labor force get ignored. Even at state enterprises retirement funds are often mingled with working capital to finance company operations. The pension system is still so haphazard that no reliable figures exist on where most of China's retirement funds are based or how they're allocated.
Since the mid-1990s China has been working to build a unified system that receives regular contributions from employees, employers and state enterprises. Overseeing this reform effort is the Ministry of Labor and Social Security, although it will eventually be up to the Ministry of Finance to manage most national pension assets.
As reform proceeds, however haltingly, contributions are expected to rise rapidly. For instance, in mid-June the government announced that state enterprises selling their shares to the public should allocate 10 percent of the IPO proceeds ($22 billion of deals were done last year) to the National Social Security Fund, set up in September 2000 to raise money for pensions, health care and unemployment.
Private plans should also see growing employee contributions as Beijing seeks to reduce the drain of pension payments on its own coffers. Under an experimental program launched last year in Liaoning province, workers contribute 8 percent of their income to a mandatory fund. If this three-year test proves successful, the program is sure to be rolled out in other provinces.
To enhance investment returns, the government is allowing some pension assets to be invested in stocks, and a portion of that money is bound to go to fund managers like Huaan. In early July the government said the Council of the National Social Security Fund would invest in the forthcoming IPO of China Petroleum & Chemical Corp. This will be the NSSF's first equity holding, as it has invested so far only in government bonds and bank deposits. In August the NSSF was allowed to invest up to 6 billion yuan in stocks.
This is only a start, of course. China, an extremely poor country, is a long way from becoming a major asset management market. GDP per capita has run about $800 in recent years. The comparable figure for Singapore is $37,000; for Hong Kong, $23,500; for Taiwan, $13,300; and for South Korea, $8,500. China's population is roughly 50 times Taiwan's, but its assets are not even three times as much.
Serving a huge but widely dispersed base of customers with meager incomes is hardly the usual recipe for success in asset management. Other problems seem almost as intractable. Even well-heeled investors in other parts of Asia have hesitated to embrace mutual funds, preferring to invest directly in their local markets, thus avoiding fund front-end charges that typically run about 5 percent. Mutual funds were introduced in Hong Kong about 20 years ago, yet only 8 percent of residents own them, compared with nearly half of all Americans.
China's own three-year-old fund management industry hasn't fared particularly well. The 14 licensed fund managers have total assets of just 56.2 billion yuan in 35 closed-end funds listed on the Shanghai and Shenzhen stock exchanges.
Admittedly, the firms haven't always helped their own cause. Most became embroiled in a major scandal late last year that still isn't completely resolved: The feisty financial magazine Caijing charged that senior fund executives manipulated the markets to aid one another, and the CSRC found irregularities at eight of the ten firms it investigated. Beijing-based Boshi Fund Management Co., the country's biggest, was singled out by the CSRC for extreme irregularities and suspected fraud. The securities watchdog is mulling possible sanctions against Boshi.
One omnipresent risk is a change in China's political direction. President Jiang Zemin as well as Premier Zhu Rongji, who is the architect of many of the financial reforms, are expected to step down next year to make way for a new generation of leaders. "After the party congress in the fall of 2002, power will be transferred to a younger generation - that's a big change," says one senior Chinese financial executive. Although the new leaders are expected to stay the course of Jiang and Zhu, fear of political surprises has kept numerous foreign firms from moving more aggressively into the Chinese market. "Many overseas firms want to see clear policies and think it is best to wait until after next year's party congress," says the executive.
The technical-cooperation agreements foreign firms have signed with fund managers could conceivably be in jeopardy. Nonbinding, they're merely a prelude to foreign firms' being allowed to own Chinese asset management houses. Once China joins the WTO, foreign firms will be allowed to buy one-third stakes and after three years, 49 percent shares. CSRC adviser Neoh is confident that "after five years foreign fund managers will have the ability to have fully owned firms" (assuming China's WTO bid doesn't go awry). But the concern of some foreign firms is that the new political leadership may delay the links or make them unduly onerous for foreign buyers.
For a start, the links are anything but ironclad. "These are courtships with no guarantees of marriage," says Leckie. A rule on joint ventures between foreign fund management firms and Chinese entities is not even likely to be published until early next year. Nor is it clear whether foreign firms will be able to buy stakes in existing fund managers, thus gaining entr,e to their customers, or whether new entities must be formed.
The list of concerns is serious enough to have dissuaded some deep-pocketed players from pursuing asset management business in China. Both Axa Investment Managers and Fidelity Investment Management say China is not high on their Asian priority list. As a matter of corporate policy, Fidelity won't operate as a minority joint venture partner, so it won't enter China until it can do so on its own terms. Axa Investment chairman and chief executive Donald Brydon said recently in Hong Kong that the firm had no immediate plans to build an asset management business in China. Making significant headway in a partially open market like China's isn't easy, noted Brydon. Instead, Axa prefers to focus on developed markets like Hong Kong, Japan and Singapore.
Still, a large number of major players are more than willing to take the risks and put up with the inconveniences. "You're better to get in early, really learn the ropes and get the best staff, rather than throw billions at it later trying to catch up," advises Blair Pickerell, managing director of JF Asset Management and the Asian unit of J.P. Morgan Fleming Asset Management and the biggest retail mutual fund provider in Hong Kong and Taiwan. Says Leckie with a shrug, "You could wait for a hundred years for things to be clear in China."
Many of the enter-China-now managers find it reassuring that the country's often lumbering bureaucracy has shown an unusual resourcefulness in cultivating the open-end fund business. The government is showing a preference for Chinese firms with a solid relationship to a major foreign firm. "The guideline is that when we submit an application, there should be some evaluation done on it by our foreign partner," says David Yu, head of business development at Beijing-based Da Cheng, which hopes to launch its own open-end fund. "The government expects you to find very reputable firms." China also requires that foreign partners have at least $50 billion in assets and Chinese experience.
The CSRC went so far as to put together a committee of senior executives from foreign firms to assess the candidates lining up to launch China's first open-end fund. Individuals from HSBC, J.P. Morgan, Schroder and State Street Global Advisors all participated, though not officially on behalf of their firms. Han's Huaan fund was unanimously selected on the basis of a variety of criteria, including a solid back-office system, an innovative sales and distribution plan, management strength and a sound fund strategy.
Assuring the fund's stability was a top priority for Han and the government. Huaan hopes to overcome Chinese investors' tendency to jump in and out of markets by charging a smaller than usual front-end load of just 1.5 percent and an annual management fee of the same amount. To discourage redemptions the fund will charge a back-end load of 0.5 percent.
Anxious to avoid attracting speculators, Han, with the CSRC's encouragement, decided to sell the fund exclusively through Bank of Communications. His fear was that if securities firms sold the fund, too many of the buyers would turn out to be short-term speculators. By selling through the bank instead, Han aims to attract older, more conservative bank depositors to buy and hold stocks. The CSRC's Neoh confirms that one of the government's prime objectives in pushing open-end funds was to attract a new type of investor: risk-averse savers 40 to 59 years old.
Distributing through a bank also gives Huaan the sort of geographical reach and penetration that no brokerage in China even approaches. And it adds credibility. As Bank of Communications' Gu puts it, Chinese customers "think that what banks sell is 100 percent safe." And in fact, this marks the first time that a Chinese bank has ever offered its customers a "risk" product. Bank of Communications has prudently put together an educational program to explain what an open-end fund is and what risks it entails. And it's making sure that investors recognize that the fund is not the bank's product.
Han wisely isn't relying solely on finicky retail investors. Of the fund's 5 billion yuan, 60 percent came from individuals but 40 percent came from insurance companies and other institutional investors, such as corporations and university scholarship funds. (Insurers have recently won permission to invest up to 15 percent of their assets in stocks through third parties.) The theory is that with a balanced investor base, the fund can limit withdrawals.
The CSRC has taken its own precautions. To help maintain the fund's stability, for instance, it is requiring that 20 percent of all open-end funds be invested in government bonds. Several institutions, including the Shanghai Stock Exchange, plan to create special benchmarks for the funds.
Han won't be shying away from what he deems to be reasonable risk. The Innovation fund was planning to put its money into technology companies and traditional entities using groundbreaking processes when it started investing at the end of September. "Innovation is the sweet part of China's economy," says Ernest Liu, one of three fund managers who will oversee the new fund. Liu says personal-computer makers, cellular telephone companies and firms handling outsourcing work for multinationals are all likely to appeal to the Innovation fund's managers. Dot-coms? "We'll only invest in companies that have positive earnings," says Liu.
Han Fanghe is acutely aware of the burden of being China's first open-end fund manager. He and his colleagues are operating "in the dangerous part of the financial services industry," he says. "If you make money, they love you. If you lose it, they hate you." In Han's case, success or failure will engender strong emotions in more than just investors. In effect, he's got a whole industry hanging on his efforts.
Return of the natives
To build a mutual fund business, China is relying on a cadre of young, Chinese-born financial professionals who've worked on both sides of the Pacific.
Ernest Liu, 32, a fund manager for Huaan Fund Management Co., and Cary Zhang, chief strategist in Fullgoal Fund Management Co.'s marketing department, are two of the returnees, both based in Shanghai. Like others in their elite group, they boast unusual credentials: American fund management expertise combined with a firm grasp of the Chinese language and culture.
Their Sino-American r,sum,s qualify them for ground-floor positions in a market with phenomenal growth prospects: China has 6.7 trillion yuan ($817 billion) sitting in low-yield bank savings accounts, and its pension assets are forecast to reach $1.8 trillion by 2030 (story). "China has a lot of opportunities for people like me," says David Yu of Da Cheng Fund Management Co., who formerly worked as an analyst at the Vanguard Group.
The China Securities Regulatory Commission has hailed the homecoming. Indeed, in February the securities watchdog hired an American, Laura Cha Shih May-lung, who'd been deputy chairwoman of the Securities and Futures Commission of Hong Kong, as one of its four vice chairmen.
Moreover, the commission has been pushing Chinese money managers to form links with foreign firms. "The CSRC has encouraged the first contenders for the launch of open-end funds to get technical assistance from experienced open-end fund operators in other markets," says Anthony Neoh, senior adviser to the CSRC.
Huaan's Liu, who earned his MBA at Tulane University, worked as an equity analyst for U.S. Global Investors in San Antonio, Texas, and as an investment banker for Chaffe & Associates in New Orleans before returning to China in 1999. "Back in the U.S. I would be just one of thousands of analysts, but in China I'm at the top," he says. "You get personal satisfaction that money can't buy."
That's lucky, because the money is hardly an inducement by American standards: Liu took a 50 percent pay cut. What does he miss most about the U.S.? Driving his own car: "Maintaining a car is much more expensive here," he says. "I always take taxis." But that is a minor hardship, Liu explains, when measured against the joy of being reunited with family and friends in China.
Fullgoal's Zhang, 35, a Columbia Business School graduate, interned for UBS Warburg and then spent two years in its private banking group catering to wealthy Chinese immigrants in California's Silicon Valley. But the repatriated analyst always knew he'd return to Shanghai someday, because, he says, "the place for my career ladder is where I grew up." -K.H.
