Growth opportunities tempered by uncertain regulatory environment

China's inexorable march to an open economy from a closed, tightly controlled one has been a double-edged sword for local fund management companies, expanding the scope and scale of their business opportunities while adding a huge element of guesswork to strategic planning.

The past few years have seen a pickup in the pace of reforms in China that have altered the competitive landscape, including:

  • a breakdown of the regulatory walls separating financial firms managing assets for a fee, allowing trust companies, securities companies and insurers to set up fund management firms, and fund management companies to do trust-related business;

  • the setting up of a Shanghai free-trade zone promising fewer restrictions on capital and currency flows; and

  • a dramatic expansion of quotas for cross-border investment.

On balance, fund management executives see long-term gold in those reforms, even if their business for the past five years has failed to keep pace with the 7% to 9% annual expansion of China's economy.

Deregulation will be the biggest driver of the fund management industry's growth, setting the stage for product innovation and an expansion of services that will open up “tremendous opportunities,” said Allen Yan, deputy CEO of Shenzhen-based Rongtong Fund Management Co. Ltd.

“If China is going to work, then the industry will work. It's only a question of how much pain you have to go through” to get there, said Stuart Leckie, founder and principal of Hong Kong-based pension consulting firm Stirling Finance Ltd.

If reforms promise new opportunities, they've also left fund management executives in China in a difficult situation when it comes to drawing up business plans.

With the regulatory environment in China as volatile as the markets, it's not really possible to predict, with confidence, what the competitive landscape will look like two or three years down the road, said Liao Cheng, Tokyo-based director, Asia business development, with AXA Investment Managers. Instead, Shanghai-based AXA-SPDB Investment Managers Co. Ltd., AXA's joint venture with Shanghai Pudong Development Bank, “prefers to focus on improving our investment performance and building up strong relationships with our clients,” he said.

That's an approach more fund management companies in China would do well to adopt, some industry watchers say.

One industry consultant, who declined to be named, said building credible investment organizations has taken a back seat to “playing with the China Securities Regulatory Commission” — effectively looking to profit from the next bout of regulatory reforms. There are exceptions, such as Shanghai-based AEGON-Industrial Fund Management Co. Ltd. and Shenzhen-based Invesco (IVZ) Great Wall Fund Management Co. Ltd., which have focused on performance, as opposed to throwing out as many new funds as possible, market veterans say.

Some industry executives insist broader economic reforms will eventually provide support for a fund management industry that has suffered as the global financial crisis's fallout shifted the focus of Chinese retail investors from equities to fixed-income and money market strategies.

Money market funds and short-term fixed-income strategies have become more popular on the back of huge spreads between the yields they offer and bank deposit rates that remain controlled by China's central bank — a situation that could persist for the next few years, said Xu Lirong, chief operating officer of Shanghai-based Franklin Templeton (BEN) Sealand Fund Management Co. Ltd.

The latest monthly data from the Asset Management Association of China show that multiyear trend shifting into high gear this year, with the success of a growing number of money market funds distributed by Internet companies adding to the momentum.

According to the Asset Management Association of China, combined assets under management in mutual fund vehicles for China's fund management companies jumped 18% to 3.55 trillion renminbi (US$573 billion) in the first two months of 2014. During that time, equity fund AUM slipped 4.5% to 1.05 trillion renminbi, while balanced fund AUM edged up 3.6% to 583 billion renminbi. By contrast, money market fund AUM surged 90% to 1.42 trillion renminbi — a pace that leaves that segment poised to surpass the combined AUM of equity and balanced funds by the end of March.

Terrance Hui, CEO of Invesco Great Wall Fund Management, predicted that recent “tremendous growth” might not be sustainable. Over the coming year or two, liquidity is likely to flow back to equities, where industry analysts say IGW has earned a reputation for strong performance, and longer-term fixed income, where IGW is building up its team.

Xu Lin, special assistant to the CEO of Shanghai-based HFT Investment Management Co. Ltd., pointed to the artificially high level of “risk-free” rates in China, following the huge stimulus package China's government deployed to offset the impact of the 2008 global financial crisis, as the main issue — driving the explosive growth of demand for wealth management products and the AUM of trust companies.

HFT's Mr. Xu said he's “moderately optimistic” the eventual introduction of a more normal interest rate curve will force Chinese investors to adopt a more sophisticated appraisal of market risk, which in turn will prompt money to flow back into equities from supposedly risk-free trust and wealth management offerings.

Some observers say that trend already has begun with China's first domestic bond default in March by Shanghai Chaori Solar Energy Science & Technology Co. Ltd.

While the company is just a “pebble” in China's corporate ocean, the simple fact that a default finally occurred could have an outsized impact in getting investors in China to review their assumptions about risk, said Tim Pagett, Hong Kong-based financial services partner with Deloitte Consulting (Hong Kong) Ltd. If so, that default could prove a noteworthy milestone in the evolution of more mature capital markets and a more mature fund management industry there, Mr. Pagett said.

Competition in the industry looks set to become fiercer, with regulators — after putting financial firms in different silos with distinct competitive advantages — now opening up the field “to everyone,” said Ying Tan, a Hong Kong-based manager researcher with Mercer.

If that market opening eventually frees foreign money managers from current rules limiting them to a 49% ownership stake in the equity of China-based fund management firms, that should lead to a bevy of interesting discussions among the stakeholders of the close to 50 joint venture firms in the country now.

Some market participants believe the joint ventures can persist.

“I don't see partners going their separate ways,” said Invesco Great Wall's Mr. Hui. Joint ventures have a niche for overseas investors, which should prove durable over time, he said.

Others see greater centrifugal forces at work.

“Like any marriage, a number will end up in divorce,” if the ownership limits that brought many foreign firms to the altar in the first place are dropped, said Bonn Liu, a Hong Kong-based partner with KPMG LLP, and practice leader for the firm's China securities and funds practice.