Assets under management among ChinaÆs mutual-fund companies is expected to drop by 16% to Rmb1.4 trillion ($204 billion) by the end of 2009, which will put enormous pressure on the profitability on many (possibly most) players, predicts Z-Ben Advisors, a Shanghai-based consultancy.

According to a report written by Z-Ben analyst Michael McCormack, fund managers face ôChinaÆs version of Catch-22ö because even if equity markets reverse and perform above expectations, there is a high chance that many investors will use the opportunity to redeem rather than to participate in the market. Mainland investors tend to look at fund NAV, and those funds currently below par (usually 1Rmb) may suffer redemptions when they return to par.

The consultancyÆs best-case scenario for the industry next year is to see AUM rise to Rmb1.7 trillion, provided that equities outperform expectations, most investors surprise by holding tight, and more institutional investors participate in new fundraisings.

But things could go the opposite way, with retail investors divesting, institutions clawing back allocations, and domestic capital markets continuing to be marred by poor conditions; Z-BenÆs worst-case scenario is industry AUM at Rmb900 billion by end-2009 û in which case more than 50% of fund companies will be unprofitable.

ChinaÆs fund companies face a number of pressures next year. Authorities have okayed three more bank-led JV firm licenses, as well as several more greenfield joint ventures, which means more players battling over a shrinking pie.

Insurance companies, which have been steadfast investors in the funds industry, are expected to move more of their allocations to the growing number of insurance-owned asset-management companies; they may also claw back or halt new mandates in order to allocate more to other asset classes, including trusts and real estate.

This will only add to growing pressure from institutional investors for reduced fees in segregated accounts, and a move to shift assets out of high-fee commingled funds. Retail investors lack such power, but commercial banks continue to enjoy an oligopoly on wholesale distribution, and will continue to demand a big trailer fee.

At the same time, fund houses will be under more pressure to go after retail investors, which requires not only generous cuts of the management fee to banks, but also renewed investment in IT, marketing, customer service, and portfolio construction.

Add this up, and certainly the smallest third of the industry is going to lose money in 2009, and possibly more than half of the industry if conditions stay bad. And even for the biggest companies, profits will be difficult to achieve û but a new tier of winning companies is going to emerge, comprising a minority of large, savvy players who are able to use the downturn as a means of separating themselves from the mediocre middle.

ôWe expect the best firms to be very easy to identify in 2009,ö says McCormack.