Only one in three Hong Kong fund managers is using the Stock Connect trading scheme with Shanghai two months after launch on account of technical and legal issues, new research shows.

A Hong Kong Investment Funds Association (HKIFA) survey of 41 fund houses with $20 trillion in AUM overall found that only 13 (32%) had invested into A-shares via the trading link so far.

Usage is primarily limited to Hong Kong domiciled funds, unauthorised funds, proprietary trading and other institutional mandates. Long-only managers are noticeably absent.

The scheme was launched on November 17, but trading has been slim. Total northbound trading has reached Rmb77 billion ($12.4 billion) since launch, or 26% of the aggregate quota.

Nevertheless, the survey pointed to the scheme's potential, with 53% of responding firms saying they planned to use it within the next 12 months. The remaining 47% indicated interest, but said their participation depended on getting clearance from regulators, depository banks and clients.

“The level of flows we have seen so far does not fully reflect the potential demand on Stock Connect because of some technical and legal issues,” said Bruno Lee, HKIFA chairman, at a media briefing on the scheme yesterday. He said long-only members of HKIFA were keen to participate, but needed to wait for clarification on certain issues.

In all, 85% of managers cited beneficial ownership as a key issue that needed to be addressed, while 65% pointed to pre-trade checking and 38% to disclosure of interest (DOI) and the short-swing profits rule (SSPR).

Beneficial ownership refers to stocks owned by foreign investors held in a separate account controlled by the Hong Kong Securities Clearing Company. This causes problems with European regulators that require investors to have clear legal ownership of shares.

“The issue of beneficial ownership is particularly pertinent for Ucits funds domiciled in the European Union because the regulator has strict requirements on ownership and asset segregation,” explained Lee.

Pre-trade checking requires shares to be delivered to brokers at least one day before trade settlement. DOI, under the China Securities Law, requires investors to make disclosures when any shareholding exceeds 5%. SSPR is an anti-insider trading rule requiring particular shareholders to forfeit profits made on their holdings if they are acquired within six months.

Of course, Hong Kong is awash with Ucits funds domiciled in Europe, which is likely to explain the low usage figures for Stock Connect given the hurdles still in place.

In Hong Kong as of last March, just 469 funds (24%) were domiciled domestically, accounting for 7.6% of total net asset value, compared with 1,305 funds (66%) domiciled in Luxembourg, Ireland and the UK, or 88.2% of total NAV, by figures from the Securities and Futures Commission.

Lee added that large fund houses had hesitated because of DOI and SSPR, saying the rules had made it difficult for managers to fulfil their fiduciary obligations. 

“DOI brings challenges to international investors because the definition of what investors have to include is not clear, the rule is only a high level of principle guidance,” noted Sally Wong, HKIFA chief executive.

“For many international firms that have different subsidiaries such as investment banks, venture capital and asset management, it's very easy for them to trigger 5% holding rules if they have to aggregate across the board.”

Wong stressed these were challenges especially for managers forced to replicate an index, adding that such rules needed further clarification.

But the association is optimistic about the trading link’s development. Lee noted that Hong Kong Exchanges and Clearing had pledged to implement solutions addressing the pre-trade checking issue.

He pointed out that among the 53% of respondents planning to use Stock Connect in the next 12 months, 86% of those aim to do so in next six months. Lee said this reflected members’ confidence that the issues would be resolved soon, and said he was optimistic that usage would then grow.

Asked if Stock Connect had had an impact on Hong Kong retail fund sales, Lee observed that Greater China funds accounted for just 3% of retail fund sales in Hong Kong during the first 10 months of last year to the end of October, before Stock Connect was launched. 

He expressed the belief that retail investors would soon participate in Stock Connect via exchange-traded funds or retail funds since the A-share market had rebounded in recent months.

Looking ahead, the survey found that firms approved of Stock Connect's expansion to non-index stocks, shares listed on Shenzhen stock exchange and the mooted Bond Connect programme. 

Asked if Stock Connect reduced the attractiveness of the RQFII (renminbi-denominated qualified foreign institutional investor) and QFII schemes, 30% of respondents indicated it would not, while 65% said it was difficult to judge at this stage.

However, 68% of respondents saw Stock Connect, RQFII and QFII as complementary.