For all the billions of dollars that have been pumped into the foreign-focused products launched by China’s fund management companies in recent weeks, judgment day won’t come until just after Christmas.
On December 27, the three-month lock-up period will end on China Southern Fund Management’s Enhanced Global Balance Fund, released under the Qualified Domestic Institutional Investor (QDII) scheme and able to invest all of its money in overseas equities.
The fund received subscriptions worth a total of US$6.67 billion when it launched in mid-September. As a result, the regulator is to increase the fund quota to US$4 billion from US$2.5 billion.
But if investors aren’t happy with the returns China Southern generates, they will leave as quickly as they came in.
“All these QDII products are likely to face stiff selling pressure once they come out of their lock-up periods, because they are just too big,” said Peter Alexander, principal of Shanghai-based fund management consultancy Z-Ben Advisors.
“What will determine the size of these outflows is fund performance. Local investors have become accustomed to a 100% return per annum.”
A shot in the arm
There is little doubt that the launch of China Southern’s fund gave QDII – which not only allows investors to diversify their assets but should also channel excess liquidity out of the country and ease pressure on the renminbi – some much-needed momentum.
Not long after, China Asset Management Co (China AMC) and Harvest Fund Management together raised over US$16 billion for QDII funds worth just US$4 billion each. In mid-October China International also hit its US$4 billion target within hours of launch and similar performances are expected from Fortis Haitong and Fortune SGAM in late October or November.
According to Jing Ulrich, chairman of China equities at JPMorgan, US$90 billion is likely to leave China via QDII funds in the next year, a third of it headed to Hong Kong.
“The experience of China Southern Fund Management has boosted confidence in the prospects for QDII funds,” said Chris Ryan, CEO of ING Investment Management Asia Pacific. The joint venture company in which ING has an interest, China Merchants Fund Management, is one of what Ryan believes are around 20 firms that have put in applications to launch QDII funds.
The success of China Southern’s QDII fund – and the ones that have followed it – is largely built upon lessons learned from the pilot scheme run by Hua’an Fund Management in association with Lehman Brothers, which debuted last November. According to the fund’s mid-year report, published in August, it generated a return of just 3.8% from inception to the middle of 2007.
“The investment strategies of these two funds [Hua’an and China Southern] are quite different,” said Zhou Liang, head of China research for fund intelligence service Lipper. “Hua’an was a guaranteed return fund, which means the revenue is guaranteed but potentially not as high as an equity fund like China Southern’s.”
This commitment to protecting investors’ bottom-line – and the lack of regulatory guidelines at the time – meant Hua’an and Lehman Brothers developed highly structured products which directed most of the money into three global funds controlled by Lehman Brothers.
The new funds will likely be more aggressive. Equity exposure can be up to 100% of assets, which are divided between direct purchases of stocks and mutual fund investments. The initial focus will be on Hong Kong stocks, but China AMC, for example, has license to invest in nearly 50 different markets.
On a far more fundamental level, these funds are cheaper to buy into than Hua’an’s and charge lower management fees. Investors can enter the China Southern fund for as little as RMB1,000 (US$130) as opposed to the minimum purchase level of US$5,000 for Hua’an.
And, most importantly, the new products are designed to closely resemble locally-invested funds.
“We advise clients to keep the product as simple as possible so investors are comfortable buying it,” said Alexander. “With local products, fund managers have come out and tried to do something different that seems great, but it flops because investors don’t understand it.”
However, the buzz that has surrounded the launch of these funds doesn’t necessarily indicate a widespread appreciation of the rationale for diversifying into overseas assets. A lot of investors are buying in not because of what the funds do so much as because they are there.
“When investors find a new fund they give it a very warm welcome, and this results in large subscriptions,” said Zhou. “There are still a lot of investors who are not clear about the investment objectives of these funds.”
This puts fund performance under even more pressure.
First, the current pent-up demand is likely to be eased by rising supply. In the near term, more locally-invested funds will be approved and, in the medium term, more QDII funds will be launched. Z-Ben Advisors expects at least 18 new QDII funds in 2008.
Then there is the issue of generating sufficient returns to keep investors interested. It seems unlikely that fund managers will be able to match in the global market the percentage gains being delivered by locally-invested funds.
This battle to make the grade could lead to tensions between local managers and their foreign advisors. Mindful that some of these partnerships have been made at relatively short notice, Z-Ben Advisors tells its foreign clients that they should be clear on the division of responsibilities before getting involved.
One for the future
Despite the current hint of uncertainty, QDII funds appear to be a safe long-term bet.
As Zhou points out, when Taiwan launched its equivalent of QDII funds, the local market was very strong so the new products attracted little interest. However, subsequent dips in the market have seen investors flock to foreign-focused funds as the returns are comparatively higher.
But according to Alexander, more needs to be done on the educational front if Chinese investors are going to start looking beyond the short-term gain.
“This market has only been in existence for a decade,” he said. “You can’t expect suddenly to realize that they have to hold onto a fund for five years.”