With the Hong Kong-China mutual recognition fund scheme under way, investment research firm Morningstar has highlighted challenges in selecting China products for distribution into Hong Kong.

While most distributors tend to pick well established Chinese managers with large funds, research house Morningstar has called on gatekeepers not to ignore the mid-sized firms and products, as they could provide better performance.

Wing Chan, Asia head of manager research at Morningstar, said onshore China funds are under-researched. Portfolio managers at mainland firms tend to be less experienced and less prepared for questions from distributors. Hence distributors tend to go with larger firms or those that have an office in Hong Kong, as they are easier to engage with.

But Chinese funds are being launched on a weekly basis, so it pays to widen the fund universe, Chan said. Despite the size of the China market, there are capacity issues for larger onshore funds that could affect performance, he added, while smaller players do not face the same challenge.

Morningstar has come up with a list of best fund ideas for the onshore China market for the second half of 2015, which includes a significant proportion of mid-sized players. It comprises five allocation funds, six equity funds and six fixed-income funds.*  

In researching onshore funds generally, Chan said one of the challenges was finding portfolio managers with a track record of 10 years or more.

One reason for this is regulatory liberalisation, combined with China’s equity bull market of recent years - until the recent correction. These factors allowed the more experienced portfolio managers to switch from running public mutual funds to start their own private strategies. Hence many experienced managers with longer track records have already left the mutual fund industry.

"If you’re looking at the people and investment process of a fund," said Chan, "you would like to see a stable team, which has been hard to come by in the past year”.

A further issue is that offshore funds tend to be more benchmark-aware, while mainland portfolio managers focus more on selection of securities and sectors. This tendency has resulted in massive performance dispersion within fund categories, as well as higher portfolio turnover, which drives up costs for end investors.

“The cost of investing in China certainly is on the high side, as it is a relatively inefficient market," Chan noted. "But if you find the right fund, it can still outperform the benchmark by a relatively wide margin.

“There’s a massive dispersion between the best and worst managers, so it is important to find the right fund,” he added. “The risk of not finding the right one can be quite large.”

The MRF scheme launched on July 1 and allows funds from China and Hong Kong to be sold across the border. Mainland firms that have announced plans to participate include GF International and China Universal Asset Management.

*The list comprises: Fullgoal Tiancheng Dividend Dynamic Asset Allocation, Lion Dynamic Asset Allocation Mixed Type Fund, Lombarda CN New Blue Chip Dynamic Asset Allocation, Huashang Leading Enterprise Mixed Open, Fullgoal Tianhui Selected Growth Mixed, Industrial Global View Securities Investment Fund, HuaShang Theme Selected Stock Fund, GF Industry Leading Stock A, IGW Core Competence mix, China Universal Private-owned Enterprises Fund, ABC-CA Small and Medium Cap Equity Fund, China Universal Enhanced Bond Fund, Great Wall Active Return Increase Bond A , ICBCCS Seasons Income Bond Fund (LOF), DaCheng Bond Fund, CCB Principal Double Interest Dividend Bond Fund, E Fund Increasing Return Bond Fund.