China’s pioneering exchange-traded fund (ETF) Connect scheme with Japan has not been an overwhelming success, but that is not stopping the China regulator from planning another such tie-ups with Singapore after introducing its second ETF Connect scheme with Hong Kong in August.

The China-Japan ETF Connect scheme, which uses a feeder-fund structure and was launched in June last year, was its first mutual market access programme on ETFs. Market experts believed the scheme was unlikely greatly appeal to institutional investors when it debuted, and those suspicions have been borne out. 

"The best description of this [scheme] is disappointing ... there have only been a few ETFs that have been included in the scheme so far, the turnover is being quite low," Stewart Aldcroft, senior fund industry adviser at Citi in Hong Kong, told AsianInvestor. 

To date four eastbound ETFs and four westbound ETFs have been listed on the stock exchanges in Shanghai and Tokyo. 

Aldcroft said he believes that any scheme that helps to open up the market is a positive development. But the costs of investing in the Japan-China ETF schemes are higher than in vanilla ETFs and institutional investors are very price sensitive, he added.

The Japan-China ETF Connect scheme is innovative in the sense that it makes “ETFs of ETFs” possible without major changes being required in the two countries’ differing investment trust laws, systems for settlement and registration, taxation and financial instruments, a spokesman at Nikko Asset Management told AsianInvestor.

Under the scheme, Japanese and Chinese ETF providers create feeder ETFs that invest in Chinese or Japanese asset classes, using an index as a benchmark. The feeder ETFs invest mainly into an ETF located in the other country that is managed by a counterpart provider. This arrangement is based on a special investment quota for the scheme that is provided by China's State Administration of Foreign Exchange.

Using a feeder-fund structure is less appealing for investors, but it also makes things simpler and quicker. One reason why the China-Hong Kong ETF Connect was delayed for so long (it was first discussed back in 2016) is because of the differences in settlement rules in the two markets, said Aldcroft.

However, ETFs operating with a feeder-fund manner have drawbacks. For a start, because they essentially operate by having one ETF invest into another one; the execution costs that are relatively high when compared to many other ETF products, which makes them more expensive than straightforward ETFs, which often charger less than 20 basis points in fees. 

Another factor potentially putting off investors is that the closing price of the target ETF may deviate from the underlying index, depending on its liquidity, which would cause a tracking error, the spokesman said.

Furthermore, the asset manager needs a reciprocal partner asset manager in the other country for the scheme to work, so it is impossible to conduct business unilaterally, he added.

MORE ETF CONNECTS

The China-Japan ETF Connect began operating just a week after the start of the Shanghai-London Connect, in which trading is conducted through global depositary receipts (GDRs). China has since launched an ETF Connect with Hong Kong in August.

The China-Hong Kong ETF Connect, which finally took place after much delay, is also using a feeder-fund structure. The Securities and Futures Commission (SFC) said on August 28 that it had approved the listings of two ETFs, which will each invest in an ETF currently listed on the Shenzhen Stock Exchange (SZSE). Likewise, two ETFs were allowed to be listed on SZSE to invest in a Hong Kong-listed ETF. Their costs are also likely to exceed those of vanilla ETFs. 

The China Securities Regulatory Commission (CSRC) is next planning another connect scheme with Singapore, although a specific timetable has not been announced. Jiao Jinhong, the chief officer for legal affairs at the watchdog, said in a financial summit this week that it was studying the feasibility of the scheme with Singapore because the lion city has become one of the main destinations of securities firms in China.

He did not elaborate further on the plans, but said CSRC will continue to strengthen regulatory work with Singapore and exchange relevant information.

These connect schemes came as China is keen to open up its financial market. Starting this month, its two major inbound investment programmes - Qualified Foreign Institutional Investors (QFII) and the RMB Qualified Foreign Institutional Investors (RQFII) – have merged and their quotas removed, as Beijing moved to ease access to the country’s capital markets.

China's first mutual market access scheme was the stock connect schemes that link Hong Kong with Shanghai and Shenzhen in 2014 and 2016.