Asset managers in Hong Kong fear "exorbitant" distribution costs in mainland China will lead to razor-thin profit margins in the initial years of the pending cross-border mutual recognition scheme.

Eleanor Wan, chief executive of BEA Union Investment in Hong Kong, acknowledged that while the market opportunity was huge, distribution channels in China were narrower on account of the dominance of the big four banks, meaning competition for shelf-space would be more intense.  

“Another challenge is the distribution fee, which is more outrageous than what we see here in Hong Kong,” she added. Marketing and associated costs are expected to be high on account of the size of the market and lack of investor sophistication.

Fund houses typically pay 30-70% of their trailer fee to distributors on the mainland, noted Felix Ng, senior analyst at Cerulli Associates. This works on a sliding scale based on the size of the fund house. The stronger their brand, the more bargaining power they have.

That leaves smaller houses to pay as much as 70% of their management fee to banks, compared with 10-20% for bigger houses, Ng said. In addition, an upfront fee of 2% of total investment also goes to the distributor.

Terry Pan, head of Hong Kong business at JP Morgan Asset Management, suggested fund distribution in China will be akin to Taiwan’s master agent system, only multiplied by 10 due to market size.

Once the Hong Kong-China mutual recognition scheme is launched, as is expected in the first quarter of 2015, regulators look likely to require managers in Hong Kong to appoint a distribution agent on the mainland to deal with fund retailers. An investment quota will also likely be imposed.

The industry is awaiting operational guidelines for the scheme, first announced at the start of last year, to be clarified by regulrators in both Hong Kong and the mainland. In most cases this is holding them back before committing to expansion.

“If asset managers only get a relatively small quota, say $100 million, this will determine how expansive a distribution and servicing network they can offer,” said Pan. “In many ways this will impact the type of partnership model that could be viable. In a market as large and complex as China, we need to be even smarter about our approach.”

BEA Union's Wan added:  “We will only see meaningful business scale in not less than five years. Hong Kong fund managers will need to plan in a different manner with a different market dimension. It is a long term-investment for us."

For most global players, foreign banks with China operations will be the starting point for distribution, even though they have a small market share. The China businesses of Bank of East Asia (BEA) and Citi are two that have expressed interest in distributing under mutual recognition.

BEA's general manager for wealth management in China, Percy Chan, said it would be looking for the scheme to fill in product gaps, without elaborating. The bank presently distributes QDII products, but Chan believes that having a local representative under the scheme will help distributors.

Citi's China head of wealth management, Yin Wang, noted it was eager to provide international product to domestic investors and would be looking to replace poor performing funds with new product with track record.