In the 1980s an obscure, 30-something fund manager traveled to China and met some locals who were hungry to learn about financial markets.
The manager explained to them how the U.S. and other Western countries were transforming into heavy-duty capitalist machines. As it happens, that manager was Ray Dalio — founder of what would eventually become the world’s largest hedge fund firm — and some of his Chinese contacts went on to hold high-ranking jobs within the country’s financial regulator.
Little did Dalio know how much that trip would pay off some 30 years later. On April 1, 2018, Dalio’s Bridgewater Associates opened a version of its gargantuan All Weather risk-parity fund that invests in Chinese securities. While this is intended for international clients, one focused on local clientele will not be far behind, having just received sign-off from the regulator.
For Bob Prince, co-CIO of Bridgewater and a 30-year veteran of the firm, the fund and associated opening of an investment office was the natural next step in its relationship with the country.
“We’ve had Chinese investors for a long time, since about 1993. One of our first clients was a Chinese firm that is still a client,” Prince tells Institutional Investor. “We have built great relationships with some of the country’s largest investors and have had an office there for around eight years. This has been for client service, so this is a really good natural progression for us.”
While Dalio’s name attracts attention, his firm is just one of several Western fund managers making a real effort in China. In the past 18 months, BlackRock, Schroders, and London-listed Man Group are among the well-known firms that have cemented their commitment to the country now that regulators have changed longstanding rules prohibiting them from investing in or trading securities onshore without a local partner.
These managers intend to capitalize on the growing hordes of increasingly wealthy investors — retail and institutional — in the country, as well as to cater to their clients back home who are in desperate need of diversified income streams.
The firms have good reason to want to get in on the ground floor. According to figures cited by Prince, 40 percent of all global money-supply growth last year came from China. The market capitalization of the country’s equities and bonds more than doubled from $8 trillion in 2013 to $20 trillion in 2017. By contrast, in the U.S. the figure grew from $39 trillion to $48 trillion over the same time frame.
With the long bull run in developed markets looking increasingly fragile, and with active managers failing to keep clients from escaping to passive rivals, Western investors have plenty of incentive to try out in China. What’s more, the local competition isn’t a major threat — yet. While the world’s second-largest economy boasts some of the world’s largest banks and insurers, its fund management industry is still in its infancy. The sector has not had the incentive or need to grow to the extent seen in North America, Europe, and Australia.
Savvy Western investors know an underexploited opportunity when they see one — and they have their sights set on a market that is not saturated with look-a-like fund managers all offering similar products to similar investors, and all at a similar price. Still, local firms may not be complacent for long. Western firms that want to access this huge and promising market will have to square off against firms that have the home-court advantage.
Peter Alexander, founder of Shanghai-based Z-Ben Advisors, which helps financial firms enter and set up in China, says the country has some homegrown fund management companies, but many would struggle to compete with their Western rivals when pitching for international client money.
“The hurdles to jump for putting together a request for proposal for quasi-sovereign entities, such as the largest pension and wealth funds, are too high for many local managers,” says Alexander.
If international companies look set to grab the incoming investor cash, Chinese firms have only themselves to blame, he adds.
“They haven’t invested in the due diligence practices needed, nor often hired fund managers who could actually speak to clients. Some of these local managers could have made significant investment and been able to compete on a level with international companies — but they didn’t,” Alexander says. “Instead, international managers have doubled down and will take the business.”
Perhaps more importantly, investors who have decided to put some money to work in China already know there are risks involved, says Alexander.
“You’re not going to add more risk by using a company that does not tick all your compliance boxes,” he says. “A local manager might have a nuanced outlook and contacts, but no amount of alpha is worth an investor taking additional risk.”
Until recently, international managers weren’t allowed to access these markets on their own.
Many large fund managers are already in China, but until 2016 they had to enter the market through a joint venture with a local partner (see tie-ups between BlackRock and Bank of China Co. and J.P. Morgan and Shanghai International Group). The non-Chinese partner in the deal was previously not allowed to own more than a 49 percent stake.
Since 2016, however, the wholly foreign-owned enterprise regime, which was launched by the Chinese government to entice international companies to its shores, has changed the rules of the game. Through the WFOE regime, international fund managers have been able to apply for private fund management licences, which for the first time allow them to invest and trade Chinese securities onshore as stand-alone entities.
While a partnership helped them learn about the fundamentals of the financial markets and the country’s clientele, going it alone gives these companies much more flexibility to launch their own products. Crucially, it also allows them the freedom to market their own brands to 1.4 billion potential new clients.
Z-Ben’s Alexander says the country’s authorities had fund managers firmly in their sights with the WFOE regime. It needed them to help grow, deepen, and professionalize its capital market activity, which lags its superpower peers.
The first fund manager to gain the WFOE status was Fidelity International. The firm, which manages non-U.S. funds for asset management giant Fidelity Investments, has been operating in China for more than 14 years and already runs a small range of funds for domestic investors, along with products for Western investors too.
The company has paid close attention to the market and its investors to find out what works — and what doesn’t.
Active management is key, according to Catherine Yeung, investment director for Fidelity in Hong Kong. Her firm has the largest research team of any fund manager in the region, with people based in both the special administrative region and Shanghai.
“There is little appetite for index funds, as some companies have found out,” agrees Z-Ben’s Alexander. “Investors are more risk tolerant than their Western peers — they want returns that are better than the market.”
Fidelity’s in-depth research into Chinese companies means it immediately discards up to 30 percent of all stocks on due diligence concerns. With others, the fund manager works alongside company directors to improve corporate governance and educate firms about how they might deal with an influx of sophisticated — and amateur — shareholders.
This relatively high number of stocks to avoid is tempting for international active fund managers, who are seeking less efficient markets as a way to generate alpha, which is becoming increasingly elusive in developed markets.
Many active managers’ performance against their relative benchmarks at home in recent years has been less than impressive. In 2016 just 26 percent of active U.S. equity fund managers outperformed their passive rivals, after fees, according to Morningstar. This improved to 43 percent in 2017, but the data provider still said, in its March 2018 Active/Passive Barometer report on U.S. equity funds, that investors “would greatly improve their odds of success” by favoring low-cost funds.
Standardized corporate governance, similarity in developed markets, and the salvo of quantitative easing go some way to explain the difficulty for active managers trying to outperform.
This is not the case in China.
Howhow Zhang, strategy director of KPMG China, says the country has active managers who consistently beat the market, as the financial markets are not as efficient as they could be.
Onshore China equity funds tend to have a higher upside than global managers out of Hong Kong, according to Germaine Share, associate director of manager research at Morningstar, and they have much greater volatility.
Additionally, local Chinese managers are largely benchmark agnostic, Share says, providing a community that would suit an active global player.
“Passive investment does not work in China, apart from in the short term,” says Robert Horrocks, the San Francisco-based chief investment officer of Matthews Asia. His firm has been investing in China for more than two decades. “Only around 30 percent of shares actually create value and return dividends.”
Horrocks says a fundamental approach involving “wearing out shoe leather” has worked for Matthews Asia, whose China Dividend Fund has returned an annualized 11.6 percent since launching in October 2009. By comparison, the MSCI China Index has returned 6.31 percent over the same period.
“Chinese markets are actually very transparent,” says Horrocks. “Companies have to report to the stock exchange regularly and can be asked to explain their actions — why they are attempting to raise capital again so soon after just doing so, for example.”
The key to active management in China is to probe every number and understand not just the target company, but its supply chain and place in the market, says Horrocks.
But if investment options are bountiful and investors are demanding active products, there is a niggling issue with supplying them.
“Regulators say that you need people with a certain amount of experience in key roles,” says Fidelity’s Yeung. “As a first-generation firm, we have them, but others — local and international firms — don’t.”
Retaining top talent is a problem, she says. “Our analysts are always being poached.”
With an army of well-educated, hungry graduates entering the job market each year, there is a decent supply of junior staff, but to replace an experienced fund manager is more taxing.
“Having a local portfolio manager is very useful,” says Yeung. “They know about the society and why people would like a certain thing over another.” They will also understand the policy directions on a macro scale and how they are likely to affect the population, she says.
Zhang says the process of building headcount would be a slog for global firms entering the market: “Historically, not all the necessary talents could be found in China — many have had to move their staff over. But the strategic intention to move is there for many global firms who are taking action.”
Prince says Bridgewater has been staffing its expanding presence with a mix of existing employees and new hires from China and the surrounding region and is still in the process of building it out.
Given the estimated asset growth for a retail market that is hungry for actively managed funds, it might be worth it for firms to make the effort to find the necessary staff.
Z-Ben says retail market assets hit $2 trillion in 2017 and will blow out to $12 trillion by 2028. These figures do not include any potential additional trillions of dollars that would come from a new pension system that is under construction.
The equities pool is deep enough for other international managers to get in, according to Fidelity's Yeung, but it won’t be easy for newcomers.
“If you go in thinking you’ll make a lot of money quickly, you’re going to have a wild ride,” says Matthews Asia’s Horrocks. “You need to use common sense to be successful in the long term.”
With the huge rise in the amount of capital being generated — and cash flow being turned into investable instruments — China’s regulator did not want to take the risk of there being no one to manage it all.
International firms were quietly educated and encouraged to seize the opportunity. The partnership framework that functioned over the past decade helped each side of the agreement learn vast amounts about the other’s business and environment.
Morningstar’s Share has noticed how global firms have begun investing meaningfully into their onshore investment capabilities over the past few years as they have grown more comfortable with the environment.
“These are typically investment professionals who have demonstrated capacity — and language skills — to analyze and invest in the onshore market, but at the same time are able to culturally fit into the established investment philosophy that many of these firms already have in place in the region,” she says.
Bridgewater sees the massive potential and has been impressed with not just the creation and implementation of the regulator’s action plan, but also the speed with which it has been done.
“Policymakers have been very consistent with their actions and intentions,” says Prince. “They consistently said they wanted to open up the markets to foreign managers and investors and they just want to take it at a controlled, managed pace. Some of the steps have been to simplify some of their bureaucracy or regulatory structure.”
KPMG’s Zhang says the regulator has been working toward creating a framework to allow a level playing field for global and local players.
“It is a dominant force and an influential factor in the market,” he says. “They want a regulatory framework that is fair to everyone who wants to be there. They are hoping that companies with lots of different types of approaches will be represented.”
Yet despite encouragement from the regulator and the huge potential for the rapidly growing market, plenty of large fund managers are reticent to join the party.
Z-Ben's Alexander says some firms remain concerned that the regulator will want to exert some sort of control, while some of their employees may be unwilling to stake their career on an expensive move that is yet to be proven.
For others it may come down to simple supply-demand dynamics. Despite being the world’s largest economy — and one of the fastest growing — very few major investors have distinct exposure to China. According to pension consultant Mercer, some 38 percent of European institutional investors had a general emerging-markets allocation at the end of 2017 — yet this made up an average of just 5 percent of their portfolio. There is not much room for Chinese A or H shares in there.
“Many institutional investors invest in China as part of an emerging-market mandate,” says John Belgrove, principal in investment consulting at Aon Hewitt in London. “There is a case to spin out a separate allocation, and that will come in time. Most are focusing on their risk agenda rather than returns now.”
ATP, the $120 billion Danish national pension fund and arguably one of the world’s most sophisticated investors, has barely any exposure to China — and what it does comes through one of its passive products, according to a spokesman.
Others, including the California Public Employees’ Retirement System, invest relatively tiny amounts in Chinese private equity and other alternative funds focused on a specific sector. CalPERS has commitments worth almost $7.5 million in the DT Capital China Growth Fund, according to its website. That’s a drop in the ocean to the $356.6 billion pension.
A major reason for staying away from China has been that it has not been possible to invest there in any meaningful way before now. But with the regulator’s actions to open up financial markets, and index provider MSCI including 230 Chinese A shares in its emerging-markets indexes for the first time in June, that argument will soon fall flat.
Bridgewater is keen to convince its investors to change and hopes the All Weather fund is the vehicle to do it.
“The further away you get from China and Asia, the wider the information gap and the lesser the level of activity,” says Prince.
He says the firm will guide its clients through the process of learning about the possibilities the market holds.
“This will help them understand the actions and intentions of the policymakers and offer them a portal into Chinese markets,” says Prince. “Some people get hung up on the idiosyncrasies, but what is the same about their market is much more than what is different. The basic cause-effect linkages are the same.”
Prince believes the inclusion of the A shares in the MSCI benchmark should also encourage investors, as many managers orient themselves around those indexes when they set their asset allocation.
In any case, the move by asset managers to set up shop in China will accelerate over the next five to ten years, Prince says, but it has already begun.
And Prince warns Bridgewater’s rivals that they shouldn’t miss the boat. After all, Chinese fund managers will not lag their international peers forever.
“They have the advantage of being able to look around and see what works, and they have the governance framework to implement those things,” says Prince. “They have the advantage of having no legacy — and when you don’t have the inertia of legacy, you don’t have the same degree of vested interests.”