Institutions take on new importance in China

Institutional mandates by Chinese banks are buoying local fund management companies, even as a weak domestic stock market has left their core mutual fund businesses treading water this year.

Some analysts say that institutional business could become even more important over the next few years as local regulators move to rein in another recent growth engine for fund management companies — the shadow banking-focused “subsidiary” affiliates they set up three or four years ago, which already boast combined assets under management of 11 trillion renminbi ($1.6 trillion).

A recent report by Shanghai-based financial markets consulting firm Z-Ben Advisors said heightened regulatory scrutiny of that loan-packaging business has left many fund management companies “choosing to taper (that business) and instead cater to growing institutional demand via segregated accounts.”

Ivan Shi, Z-Ben's director of research, said in an interview that with regulators effectively set to make it harder for fund management companies to be used as a conduit for banks looking to offload loans, Chinese banks have begun to aggressively shift assets on their balance sheets into fixed income. With the limited capacity of banks to manage those allocations internally, the result has been a spate of mandates for fund management companies.

“Fund management companies” — a term in China that specifically denotes firms able to manage and offer mutual funds for public consumption — are generally composed of three segments: the mutual fund-focused company; a segregated account business division able to manage mandates from pension funds, insurance companies, banks, corporations and high-net-worth individuals; and a “subsidiary” affiliate, which has been a catch-all, lightly regulated arm used for anything from non-standard financial projects to publicly traded securities.

China's regulators issued draft regulations for shadow banking activities a few months ago, proposing sharply higher requirements for paid-in capital that could force fund management companies to inject tens of millions of dollars into their subsidiaries simply to sustain the business they already have on their books. Final regulations will likely come out over the coming month or so.

When the capital required to engage in subsidiary-related businesses was minimal, fund management companies could count on volume to achieve a decent return on equity of 20% to 30%, said Allen Yan, deputy general manager of Shenzhen-based Rongtong Fund Management Co., a joint venture between New Times Securities, Shenzhen, and Nikko Asset Management, Tokyo. With higher capital requirements coming, many competitors will find the economics no longer work for them, he said.

That shadow banking business segment is poised to “slow down tremendously,” said Mr. Yan, who predicted fund management companies will strive to refocus their subsidiary affiliates' efforts on more profitable investments, such as private equity or asset-backed securities.

According to the Asset Management Association of China, in 2015 — a year that saw a wildly bullish first half give way to a savage bear market in the second half — fund management companies' shadow banking business surged 132% to 8.6 trillion renminbi, outpacing the 90% growth (to 4 trillion renminbi) of their segregated account business and the 82% gain (to 8.2 trillion renminbi) for their mutual fund assets under management.

However, for the six months ended June 30, with regulators signaling their resolve to tighten oversight of shadow banking, fund management companies' segregated accounts business posted the strongest growth, up 35% to 5.4 trillion renminbi. For the same period, shadow banking AUM rose 29% to 11.1 trillion renminbi, while mutual fund AUM dipped 4% to 7.9 trillion renminbi.

Rongtong Fund Management fit the pattern, with segregated account AUM rising 25% to 70.8 billion renminbi for the six months through June 30, while core mutual fund assets fell 9.6% to 88.9 billion renminbi and the firm's subsidiary AUM tumbled 22% to 297 billion renminbi.

Industry executives predict a variety of factors — including recent regulatory moves restricting real estate investments and others that have left banks with less flexibility in managing bond portfolios than fund management companies enjoy — could provide further momentum for institutional, segregated account mandates.

Alexandre Werno, executive vice general manager with Fortune SG Fund Management Co. Ltd. — the Shanghai-based joint venture between China's Baosteel Group Corp. and Paris-based Societe Generale Group — said changes in the past six months to tax and accounting rules for banks have provided incentives for banks to use fund management companies for their bond investments as opposed to managing them internally.

Whatever the cause, the emergence of banks as a source of mandates is changing China's institutional landscape.

“Two years ago, bank mandates were virtually unheard of,” according to the recent Z-Ben report. Now, “banks are driving rapid increases” in those managers' AUM, largely concentrated on onshore fixed income.

Miao Hui, a Singapore-based senior analyst with Cerulli Associates, and leader of the firm's China research, said in an interview that since last year, banks have become the leading institutional investor segment for many managers, accounting for more than 50% of their AUM. That trend has been especially kind to bank-backed managers, she said.

CCB Principal Asset Management Co. Ltd., a joint venture between China Construction Bank and Principal Financial Group, is a prime example, with Asset Management Association of China data showing the firm's segregated accounts AUM rising to 589.1 billion renminbi as of June 30 from 106.2 billion renminbi just six months earlier.

Keith Yuen, Hong Kong-based chief operating officer of Principal Financial's Greater China business, said in an interview that bank-owned fund management companies have been getting more mandates as China's economic slowdown cuts into corporate borrowing, leaving banks, including heavyweights such as China Construction Bank, with excess liquidity on their balance sheets.

A range of factors is contributing to the pickup in CCB-Principal's segregated account AUM, but that broad macroeconomic backdrop “explains the bulk of it,” said Mr. Yuen.

In a separate interview, Frederic Laydon, Principal Global Investors' Hong Kong-based chief operating officer, said a focus on safety and capital preservation, following a boom-to-bust cycle for local stocks over the past two years, had left the bulk of those mandates going to short-term bond and money market strategies.

CCB-Principal has accounted for a material chunk of the 58% surge in segregated account AUM posted by the top 20 fund management companies this year, said Cerulli's Ms. Miao. But even if you take that firm out of the sample, the remaining firms still enjoyed a 36% gain, she said.

Other fund management companies that saw their segregated account AUM more than double for the quarter ended June 30 included China Asset Management, up 107% to 301.5 billion renminbi; Truvalue Asset Management, up 122% to 221.9 billion renminbi; and China Fund Management, up 120% to 102.6 billion renminbi, she noted.

Michael Falcon, Hong Kong-based CEO, global investment management Asia-Pacific with J.P. Morgan Asset Management, said in an interview that institutional business has become a more important over the past two years for China International Fund Management, his firm's Shanghai-based joint venture with Shanghai International Trust & Investment Co.

CIFM, in an e-mailed statement, said that momentum has picked in 2016, with “significant inflows from local institutions since the start of this year” for fixed income-focused segregated accounts and mutual funds alike.

CIFM said the continued decline in China's bond yields, in line with global trends, has been the main driving force for that outsourcing trend — an opportunity the joint venture said it's “keen to capitalize on.”