June 15 marked a minor milestone for China’s stock markets; the first anniversary of the beginning of the huge crash that had wiped billions of dollars of value off local stocks.
The China Securities Regulatory Commission (CSRC) recognised the occasion in its own manner. On June 17 it issued a set of consultation papers for fund companies to develop fund of funds (FOFs).
It had a simple purpose for doing so: not letting a good crisis go to waste.
The mainland securities and fund industry watchdog hopes FOFs can help China’s asset managers to diversify risks and improve their asset allocation. More, it hopes that conservatively run, far-sighted multi-asset FOFs could appeal to investors still reflecting on the consequences of their stock-trading obsession.
“Without the equity market crash last summer, I think both institutional and retail investors would not care about the idea of asset allocation like they do now,” He Yunhai, director of asset allocation at Yinhua Fund in Beijing, told AsianInvestor. “Chinese investors have learned too many lessons amid market swings, and their demand for long-term stable investments has emerged.”
There is evidence of this learning pattern. Typically the country’s traditionally equity-obsessed households and investors withdraw from the markets when equities do badly. But in the months after the crash they instead began putting money into bond funds and money market funds. As a result, the AUM of the funds industry in China kept growing steadily.
China’s leading fund houses hope FOFs can capitalise on this broadening appreciation. Bosera Funds, Yinhua Fund Management, China International Fund Management, Tianhong Asset Management, China Southern Asset Management and Penghua Fund have all set up new asset allocation teams over the past three months, paving the way for the creation of fund of funds business; while China AMC revealed it had paired up with Boston-based PanAgora on July 7 to develop multi-asset risk-parity capabilities.
The enthusiasm with which Chinese fund managers are rising to the CSRC’s call over FOF development is encouraging. Yet while the vehicles could gain good support from long-term focused institutional investors, the biggest immediate supporters are likely to be commercial banks. They have slightly different priorities in mind.
The advent of FOFs is the latest in a string of recent new fund products. Over the past year, local fund managers have manufactured several different new fund types such as active, passive, exchange-traded and structured products in an attempt to re-engage local retail investors.
After the equity market crash these investors initially poured money into safe assets such as bonds and money market funds, to the point that these fund types respectively represented 11% and 54% of the industry’s total AUM in July. But the appeal of these funds is fading, given that bond yields have compressed rapidly (the 10-year government bond yield has tightened from 3.3% to 2.8% over the past 12 months).
At the same time, investors’ options have become more restricted. In August last year the CSRC started to clamp down on structured funds, or leveraged stock index-linked products, which saw huge drops during last year’s market rout. EastMoney, a financial data provider, estimates the AUM of China’s structured funds shrank 53% from Rmb470 billion to Rmb220 billion as of August. Leveraged stock index funds saw similar drops in net asset value in the months following the crash.
Then in May this year the CSRC began restricting guaranteed funds. The funds claimed to provide an 80% to 100% capital guarantee to investors, while offering an attractive yield. But they did so by investing into risky assets like equity and credits, and in fact did not guarantee the capital in all circumstances.
This has left retail investors and institutional funds, which remain eager to enhance their yields, with fewer investment products. The country’s fund managers don’t yet offer multi-asset solutions as such, but Yinhua believes insurers are likely to seek such investments to reach their stated targets.
“Product development has reached a bottleneck stage for the fund industry, and FOFs [offer a potential solution as they are] a rather safe idea, unlike risky structured funds,” said Rachel Wang, director for manager research at Morningstar China in Shenzhen.
Some insurers are already sniffing around multi-asset ideas from external providers. China Life has already demonstrated its interest in multi-asset solutions, including multi-asset mandates in the first ever overseas mandates it handed out in January 2015. Other insurers like Ping An Life are seeking to work with domestic fund managers to raise their returns, while not elevating their risks to worrying levels.
CSRC has set an ambitious vision in which institutional investors use FOFs to become more of a force in the country’s fund industry.
Zhong Rongsa, the deputy chairman of Amac, attended a conference in Beijing in July, during which she offered a blueprint to develop FOFs to service country’s pension fund needs. “The best development in US pension reform since 2006 has been life-cycle products, which use a FOF structure,” she said.
The US possesses the world’s largest FOFs product market, with $1.7 trillion in AUM at end-2015, with Vanguard, Fidelity Investment and T.Rowe Price standing as the three top players. In a response to questions from AsianInvestor, Vanguard noted 85% of its 70 FOF products are index-based target-date products, which are composed of clients’ retirement investments. The funds were offering 5.4% to 5.8% in 10-year average annual total returns as of June 30.
China appears keen to imitate the US FOF model. In a speech to fund industry players in July, Hong Lei, the chairman of Amac, said China needed to develop FOFs to offer more investment options for both pension funds and households. Industry participants told AsianInvestor the US model is a good model to emulate, as its fund industry was driven by investment from pension funds during the 1990s. China is in a similar position today, with an aging population leading to a rise in pension funds, which in turn need stable return products in which to invest.
China’s public pension funds had an AUM of Rmb3.99 trillion at end-2015 but they are only allowed to invest onshore, and most of their assets are sitting in bank deposits and government bonds, the returns of which are lagging behind an inflation rate that has averaged 2.94% between 2005 and 2015.
To facilitate reform of its pension sector, the Ministry of Human Resources and Social Security said in August 2015 that it would appoint the National Council for Social Security Fund (NCSSF) to manage about Rmb2 trillion of total public pension fund assets before the end of this year. While an exact date of kick-off has yet to be established, the NCSSF will need to source external domestic fund managers to help manage such a large pool of money.
Beijing believes the process of outsourcing funds to external fund managers will be a vital learning process for pension funds, and FOFs will be a vital component of it. “Fund companies have to build up asset allocation and product manufacturing capability via setting up FOFs, and learning from their mistakes in the process, in order to serve the country’s pension fund investments in future,” said Morningstar’s Wang.
While pension funds might be the key beneficiaries of FOFs, they seem unlikely to be the largest buyers in the initial stages.
Instead, fund managers believe commercial banks will be the most interested, as they seek ways to boost returns for their own wealth management products (WMPs). Increasingly, the lenders have been prevented from investing into debt financing and shadow banking activities to support such products. And with bond yields falling, it’s become harder for them to offer meaty WMP returns.
FOFs offer the commercial banks a potentially higher-yielding and more predictable investment option. Bosera’s Yu said the banks are eager to connect their WMPs with mutual funds that have targeted investment horizons and risk levels. By doing so, the banks will potentially be able to connect their WMPs to FOFs with stable annual returns.
Early movers have started to hand out such FOF mandates via fund houses’ segregated accounts, but they prefer highly regulated mutual funds that offer better information disclosure and daily liquidity, he added.
Ivan Shi, Shanghai-based research director at Z-Ben Advisors, says the fund managers’ client basis has shifted from retail to institutional since last summer’s equity market rout, as they seek higher yields and safer investments, and now better performance by FOFs. Institutional clients of money market funds and bond funds increased to 63% and 74% in terms unit share holdings as of June, from 39% and 59% in one year ago, representatively, according to the consultancy.
The commercial banks' push into FOFs is in some ways cynical - a naked grap for new products they can market to their clients. But it could also help expose these retail customers to products that are, if decently engineered, stable and decently performing. That would be a good result for all involved. Provided, of course, the products are well-structured.
Look out for part two of this feature story from AsianInvestor's October magazine, which examines the strength and breadth of the fund of funds being established in China.