With the help of light regulation and financial innovation, China’s trust industry has boomed in the past two years, with total assets hitting Rmb3.7 trillion ($580 billion) as of June 30, up 23% in the first half alone, and 28% since the end of June 2010.

These figures, released by the China Trust Association (CTA) yesterday, show the 65-company industry expanding fast as the domestic mutual-funds industry struggles, having shrunk Rmb100 billion to Rmb2.3 trillion in AUM over the first half. In fact, 2010 saw trusts overtake mutual funds in AUM for the first time, says a KPMG report issued yesterday.

Since the trust industry is a relatively lightly regulated part of China's financial sector, it has experienced unprecedented growth rates in the past two years, even as the government has tightened macro policies.

When banks in China are told to curb lending and mutual funds suffer losses in the volatile domestic capital markets, trust firms play a bigger role as drivers of wealth-management services and providers of much-needed debt, equity and hybrid financing, says Jason Bedford, manager of financial services at KPMG China.

However, regulators are taking note that debt trust funds, for example, are functioning as shadow banks, providing financing to enterprises by leveraging professional investors’ relatively high-risk appetite. The China Banking Regulatory Commission has started to place tighter scrutiny on trust companies in the past two months. It has stipulated, for instance, that trust projects related to real estate must be approved on a case-by-case basis.

Nonetheless, the appeal of trusts is clear, and trust companies have a large and growing pool of qualified investors to tap (each of whom must have net investable assets of Rmb1 million).

“[Trusts'] unprecedented success in the past 12 months is because they are targeting an attractive and prosperous segment of the market – high-net-worth individuals [HNWIs] and institutional investors," says Bedford.  

Moreover, trust companies have access to a wider range of asset classes than other financial institutions in China, so they often act as 'test labs' for financial innovations. Commercial banks, private-equity funds, private hedge funds and even local municipalities all seek to cooperate with trust companies.

Of the total pool of trust assets, around 28% is invested in infrastructure, 19% in corporates (direct debt or equity investments), 17% in real estate, 10% in securities and 6% in financial institutions, according to CTA data. The remaining 20% is held in unspecified 'other' assets.

In recent months, diversity in product offerings has increased to include arbitrage funds, privately managed equity funds, infrastructure funds and property funds, notes KPMG.

One successful model is private hedge funds, dubbed 'sunshine' private funds, as private fund managers, who used to operate underground, can now issue products legally to professional investors (mostly HNWIs) through trust companies.

This model has been operating for seven years and has cultivated China’s hedge-fund industry. This year, 322 private funds have launched, with the sector's AUM rising to Rmb162 billion as of June 20, from Rmb147 billion at the end of 2010, says Shanghai-based data provider Suntime Corporation. (That said, these firms have been less successful this year, posting an average return of -6.74% by mid-2011.)

In addition, trust companies remain the only vehicle through which asset securitisation is possible in China. Real-estate trust funds, which had AUM of Rmb605 billion as of June 30, enable HNWIs and institutional investors to invest in property assets, while providing finance to property developers that have difficulty obtaining bank loans these days.

This combination of diversified asset classes and innovative structures has enabled trust funds to offer better returns than fund-management companies, whose performance is highly correlated with the movement of domestic capital markets.

In the first half, debt trust products offered annualised returns of 8.35%, significantly higher than the one-year term deposit rate of 3.5%, according to Howbuy, a Shanghai-based consultancy. Most of these products are invested in real estate, corporate securities and infrastructure.