New Chinese rules governing the performance-based fees that mutual funds can charge are causing some consternation within the hedge fund industry due to concerns that they could yet spread to private securities managers. Some of the detail is also coming under fire.
Although mutual funds with flexible fee structures are relatively rare in China, the worry is that the new rules, barely a week old, will be extended through so-called window guidelines – verbal orders informally handed out by Chinese regulators from time to time.
That’s the view of a Shanghai-based lawyer speaking to AsianInvestor, who recalls how private securities funds – the Chinese equivalent to hedge funds – were caught out earlier this year by changes in the way principal-protected products are treated.
The China Securities Regulatory Commission (CSRC) first ruled that so-called principal-protected funds should be renamed ‘hedge-strategy funds’ and in February prohibited mutual funds from using capital-protection mechanisms.
But later on, “such rules were extended to private funds,” the lawyer said, who asked not to go on the record due to the sensitivity of her work.
At press time, the CSRC had yet to respond to our queries as to whether that might turn out to be the case again.
The performance fees charged by private securities funds are currently not regulated in mainland China, in much the same way that hedge fund fees are not in Hong Kong, lawyers in both jurisdictions told AsianInvestor.
Summary of new Chinese flexible-management-fee requirements
Under new rules, flexible-management-fee funds are defined as those where management fees are linked to performance.These new rules set out the types of funds that can adopt a performance-fee model, what is required of those firms that do so, and also sets the upper limits on those fees. They are designed to protect the legal interests of investors, the CSRC said.
The guidelines set out two categories of performance-based fee models. One type involves higher management fees for outperformance versus a benchmark and lower fees for underperformance. The second type only applies when the fund outperforms. Investors provide a bonus to the fund manager if the fund outperforms to a specified target over the benchmark.For the second type, the fund house must seed the fund with at least Rmb10 million ($1.5 million). At least 10% of that must come from the portfolio managers themselves.
In addition, for the second type, the high-watermark principle will be applied – that is, a performance fee is charged only when the net asset value (NAV) outperforms the preset benchmark and only when the NAV is higher than the previous year.Overall, funds that adopt flexible fee models must have either an absolute-return strategy or invest in bonds. The overall annual charge of the fund cannot exceed 5% of its average asset size during the year.
Finally, the fund manager should have at least five years’ experience of equity- or bond-related investment management. In addition, fund managers cannot receive a minimum 30% of the performance fee income for at least two years.
That’s because the level of fees that these funds can charge is regarded as a commercial matter and is in any case usually in line with market standards, such as the two and twenty rule – a 2% for management fee and 20% performance fee – said a lawyer in Hong Kong, who also declined to be named.
That said, there are some disclosure requirements, as set out in the Fund Manager Code of Conduct issued by the Securities and Futures Commission in Hong Kong. In China, the Asset Management Association of China, a self-regulatory body under the aegis of the CSRC, also issues information disclosure guidelines around the subject of fund fees.
First performance-fee rules
The increased focus in China on performance fees comes at a time when the regulatory environment for fund managers, generally, is tightening and broadening out.
“You can get a sense how tight the regulatory environment is [getting] now,” the Shanghai lawyer said, noting how the Chinese authorities have moved from institutional, tailor-made funds across the whole channel business. “Now [they] even touch the fee part, which is more of an issue between the manager and investors themselves.”
CSRC circulated draft guidelines last week on flexible management fees for mutual funds. Although not the official, final rules – and the CSRC has not said when it will publish these – they are supposed to take immediate effect.
Draft guidelines they may be, but fund managers will probably make sure any new products they launch will comply with them, the lawyer in Shanghai said.
There are 33 mutual funds in China with flexible management fees, according to data provider Wind Information. Shanghai-based Fullgoal Fund Management launched the first such product in May 2013, an absolute-return bond fund.
The Shanghai lawyer said the rule details were sensible.
However, Wang Qunhang, director of the fund study centre at Beijing-based Jian Financial Information, questioned some of the proposed new rules via his WeChat account (see box).
Wang said the two-year lock-up for portfolio manager fee earnings was too long because individuals ran mutual funds in China for an average time of just 1 year and 8 months, without disclosing the source of his data.
The range of bond funds covered was also too broad, he said, because some bond funds invested in riskier assets such as convertible bonds, so their risk level is closer to that of equity funds. As a result, they were not appropriate for the new fees scheme, which is primarily targeted at relatively stable-performing funds, Wang said.
Were it not for the precedent set by the Chinese authorities with capital-protected funds, such an observation would be a source of comfort for hedge fund managers, whose investments tend to be higher risk.
It remains to be seen whether the CSRC will tweak its guidelines to reflect the suggestions made by Wang and others in the market.