The China Securities Regulatory Commission (CSRC) is proposing a new set of rules that will make registration and licensing compulsory for fund advisory, commentary and rating providers. The rules are written with the aim of cleaning up the chaotic process of fund rating in China, where currently a plethora of professional and amateur fund commentators operate.

While no-one has attempted a complete count, the sheer number of fund rating and advisory providers that are known to exist in the market is overwhelming. The most widely quoted three are Galaxy, Tianxian and Morningstar. But the universe also includes commentators from a diverse background ranging from academics, professional rating agencies, investment consultants, research houses, banks and IFAs to financial media, web portals and bloggers.

Some charge a fee for their ratings, and some such as Morningstar and Lipper clearly don't. (Morningstar and Lipper derive the bulk of their revenue from selling their fund databases, research reports and analytic tools.) Yet a common problem is the ratings and commentaries tend to be short-term oriented. In China, fund managers are ranked daily, not quarterly or even yearly as in developed markets. The ratings and rankings are closely followed by investors and hugely influential to investors' buy-sell decisions, which contributes to the high turnover and volatility in China's fund industry.

Howhow Zhang, an analyst at Z-Ben Advisors, says the new rules from the CSRC have been brewing for years. The key is to align fund rating agencies' business models with investors' interests. It is common for fund managers to 'buy' favourable ratings, commentary and even awards from less professional providers to boost fund sales. The hotchpotch of ratings or awards is heavily featured in fund managers and distributors' advertisements. Short of mutually agreed arrangements, fund commentators blackmailing fund managers with poor comments is not unheard of in the industry.

In the new licensing regime, the CSRC will enforce a compulsory accreditation programme that will be used to vet applications for fund rating agency status with the Securities Association of China. Under the programme fund rating and advisory providers are expected to submit a report explaining their business model, any conflicted interests, and their criteria, methodology and process used to arrive at ratings, rankings or comments. Fund rating and advisory providers are expected to fully disclose their methodology in public before they can publish their results to end users.

The rules will ban fund managers, distributors and media from quoting fund ratings or commentary from unlicensed fund rating or advisory providers. This can include communications both in public (through marketing materials or conferences or media) or through indirect or private means (in communications with distributors, intermediaries or recommendations to investors).

In the current draft, the CSRC does not differentiate between retail and institutional providers, onshore or offshore. Services provided by institutional investment consultants for offshore investments in China such as Mercer and Watson Wyatt, and even AsianInvestor's China awards, can be read to fall into the CSRC's bracket as providers that recommend managers and succumb to compulsory registration. (Both Mercer and Watson Wyatt's consultants say they are checking with their general counsels on their exact status as this story goes to press.)

Furthermore, the regulator intends to ban: comparisons between funds under categories; categories that are made up of less than 10 funds; ratings for funds that have been operating for less than 36 months; ratings for funds that are yet to be fully invested; ratings based on a performance period of less than 36 months; fund ratings that are updated more often than on a quarterly basis; performance rankings for an investment period of less than three months; and rankings that are updated more frequently than a monthly basis.

Huang Xiaoping, head of research at Morningstar China, applauds the CSRC's move saying it will help correct the short-term mentality among investors that has long plagued the Chinese funds industry. But the benefits will depend on how the rules are executed.

Both Huang and Xav Feng, head of research for China and Taiwan at Lipper, believe the biggest difficulty in meeting the CSRC's rules will be how to follow the requirements in fund categorisation and rating periods.

Because of the industry's young age, when Morningstar and Lipper entered China they adjusted their ranking periods downward to one-year, two-year and five-year periods, instead of the usually longer time-frame they use in developed markets. (Huang received but turned down requests to produce daily or monthly rankings as requested by local users.)

Feng believes, given the young age of the Chinese fund industry, if the requirement of 36 months is strictly enforced, some 50% of funds in China could fall off rating agencies' radars. In newer fund categories, such as QDII funds for example, fund rating agencies may stop rating such funds altogether. This could defeat the purpose of helping investors make informed decisions in choosing fund managers.

Huang and Feng expect after the rules come into force, they will first fall back to meet Morningstar and Lipper's global methodologies, then perform tweaking and local adjustments to meet China's regulatory and market needs. The move to harmonise the periods used in China with global standards would have been a step they would take when the industry further matures.

Meanwhile, the agencies also say they have unique problems in putting funds in clear categories. The problem has come from Chinese fund managers' unique flexibility in adjusting asset allocation and loose limitations on cash holdings compared to foreign counterparts. This result in a scene that an equity fund is rarely a truly equity fund and bond funds can come with large equity holdings.

In this market, fund classification and risk profile can be expected to change over time. At Lipper, for example, Feng says he had to reclassify some 100 funds in a fund universe that currently hosts 500+ funds in China.

As seen in the financial crisis, an equity fund manager can be seen holding up to a quarter cash as he takes profit or 'park' his money as investor sentiments shift. In bull market days, bond fund managers can rely on chasing IPOs from their convertible bonds to push up rankings. Now the CSRC is advising fund rating agencies to stick to what the fund brochure says they are upon launching when classifying the funds.

On the other hand, while the rules help instil order in the chaotic retail fund universe, the rules can be problematic when applied to institutional use of fund rating agencies' databases. Institutional investors such as insurance companies, pension funds or bank proprietary desks will need to monitor their outsourced portfolios or fund holdings more often than a quarterly basis. Without fund rating agencies' advisory services, either fund managers with lesser track records will get discriminated against or investors will have to rely solely on their own due diligence.

Overall, most agree the rules are written with good intention. But judging from how wide the bracket can go, they will need more tweaking. The CSRC is open to public consultation until August 28.