China's securities and fund regulator may be keen on promoting fund of funds (FOFs) in China, but that doesn't mean they will be easy to grow. At least not in a responsible manner.
A number of sceptics question the ability of Chinese managers to develop truly multi-assets solutions.
“FOF is good… but some fund managers may not have this capability,” said Keith Neo, executive director at iFast Financial in Shanghai.
The China Securities Regulatory Commission (CSRC) requires FOFs to invest in at least six funds, with no fund allowed to account for more than 20% of assets and each requiring a minimum track record of one year. It is encouraging fund managers to structure FOFs by creating internal platforms and eliminating a layer of fees. This avoids both the underlying funds and FOF charging double fees to the end investor. The regulator has not yet offered clear guidance to managers who plan to structure FOFs by investing into external funds.
But the only players that appear capable of developing a robust FOF business are those with mature product lines that include equities, bonds, MMFs, commodities and overseas exposure via the qualified domestic institutional investor (QDII) scheme. To date, 35 fund firms offer QDII products, and only five have commodity exchange-traded funds.
“Chinese fund companies have a severe problem of product homogeneity [among their industry peers]; they will need to offer more funds which offer low correlation,” He Yunhai, director of asset allocation at Yinhua Fund in Beijing, told AsianInvestor.
This lack of development has already been flagged as a major problem among China’s immature private fund segment – the country’s hedge fund equivalents. FOF products in this sector have existed for a long time because they do not need the regulator’s greenlight, but the homogeneity of strategies among the companies has limited the efficacy of risk diversification, and only few mainland private fund firms have a full internal range of products, noted Xu Li, a researcher at Gesafe Wealth Advisory, in an email to AsianInvestor.
The CSRC has similar concerns to the public fund operators. Its new rules require fund firms to set up an independent multi-asset team that is comprised of specialists in risk control, while FOF managers cannot manage any underlying funds they invest into.
To operate successfully, FOF managers will need two capabilities: fund selection and asset allocation skills. Rachel Wang, director for manager research at Morningstar China in Shenzhen, told AsianInvestor that local FOF operators may be able to outsource fund selection, but building internal asset allocation capabilities would be a major obstacle. However, it would be wise for fund firms to learn from global rivals that have a strong multi-asset teams, she added.
Nearly all industry participants interviewed by AsianInvestor agree that fund houses and investors must evolve their investing priorities if multi-asset FOFs are to gain traction.
In other words, retail investors need to continue their shift away from short-term equity speculation, while fund houses need to become less obsessed with excelling in short-term performance rankings to market their products.
“Long-term investing has not taken root among Chinese investors; the majority hold mutual funds from six months to two years,” said Miao Hui, senior analyst at Cerulli in Singapore. In contrast, it typically takes three to five years for the diversification benefits of investing into FOFs to become apparent.
If China’s fund industry cannot overcome its shortcomings, FOFs could easily end up as a marketing gimmick. Indeed, many observers fear that fund managers already view them as such.
“Our view is that asset managers are excited about FOFs because it allows them to package best-performing funds as a best-in-class fund that might attract retail investors’ attention,” said Hui.
Both Bosera and Yinhua claim their FOF product plans are closer to multi-asset solutions, which would be target-date products that can base their investment returns on investors’ risk tolerance. However, they have some concerns.
“If fund companies follow the existing business model in ranking competition, I think the development of FOFs will be limited,” said He of Yinhua.
He argues FOFs can bring in the concept of focusing purely on absolute return targets, and being free of a benchmark. By doing so they would better differentiate themselves from existing mutual funds that are measured by their performance against specific benchmarks.
The regulator approved the FOF structure on September 23, fund managers are racing to file new product applications. But even if investors and managers do embrace the products, it’s likely to take time for them to gain a broad level of traction.
Ultimately, the success of FOFs in China will depend heavily upon the commitment of the CSRC to push the products, while discouraging the short-termism that so pervades the country’s investing culture today.
“Policy drives are at the heart of this industry’s business,” said iFast’s Neo.
The danger is that mainland FOFs could end up like the mutual recognition of funds (MRF) scheme that was launched last July and allows approved mutual funds to be sold in both Hong Kong and China. The scheme has taken off slowly so far. Northbound sales have been fairly good, driven in large part by Chinese investors seeking overseas investment, but southbound sales have been less so, with China assets not being seen as appealing.
As a result, approved Hong Kong and Chinese funds attracted Rmb3.9 billion and Rmb66 million in the first seven months this year, respectively. “[MRF] was a hot topic within asset managers and distributors; but among the investor level it’s not [been] the case,” said Neo.
FOFs have an opportunity in China. They could particularly fit growing pension funds as they seek predictable levels of return. But this asset class needs to grow in tandem with the sophistication of the mainland’s overly equity and short-term focused fund managers.
FOFs may be the future, but getting there won’t be easy.