Asia Asset Management in 2014: A J.P. Morgan Roundtable Discussion on Mutual Recognition
At the annual conference of the Hong Kong Investment Funds Association (HKIFA) in early December 2013, regulators announced they were entering the final stretch in defining the principles of mutual recognition, which will allow fund managers to seek approval to sell their Hong Kong-domiciled funds to retail investors in mainland China and China-domiciled funds to retail investors in Hong Kong.
During the conference, Alexa Lam, deputy chief executive officer at the Securities & Futures Commission (SFC) said, "It takes two hands to clap," and outlined three guiding principles already in place. These involve:
- Mutuality and respect
- A win-win situation for China and Hong Kong
- A measured, pragmatic and potentially more conservative approach to market development by Hong Kong
So when on December 13, 2013, J.P. Morgan Investor Services convened a roundtable in Hong Kong for a group of prominent Asia fund industry business leaders, including AXA Investment Managers, BlackRock, Invesco, J.P. Morgan Asset Management and Schroders, these principles were top of mind. The roundtable discussion focused on mutual recognition, and it highlighted both the associated opportunities and the practical challenges of implementation across one country, two systems.
The event also brought into sharp focus the effort that Hong Kong fund managers have put into engaging with regulators around mutual recognition and the high degree of responsibility with which they see their role in the long term growth of the Greater China markets.
Aiming toward a win-win situation
Mutual recognition extends the RMB as an investment currency, which—along with becoming a trade settlement and reserve currency—is key for its journey toward internationalization.
China could represent a massive opportunity for Hong Kong asset managers—an opportunity that should be approached carefully. Local fund managers that today dominate China's domestic market offer primarily China-listed securities funds with limited international Qualified Domestic Institutional Investor (QDII) product. It's thought that approximately 220 million mainland Chinese have invested in mutual funds offered by domestic players. Of the billions in assets under management by China's mutual fund industry, only around 2.5 percent are currently invested in overseas markets.1 Given that China's household savings rate exceeds 50 percent of GDP, the low market penetration of investment funds—and particularly of cross-border investments—indicates substantial industry growth potential, an idea confirmed during the J.P. Morgan event.
Mutual recognition is a gateway to globalizing China's asset management industry and will expose fund managers to best practices and international standards.
"The middle class and wealth are growing, and also the problems of an aging society with the same issues that we see in other countries around the need to save for retirement, education, etc.," noted Roger Hepper of J.P. Morgan Asset Management. "You have this huge dragon on the doorstep and it's very, very exciting," he said.
Simultaneously, China fund managers are poised to gain direct access to local and international clients in Hong Kong who wish to invest in the mainland. Mutual recognition is a gateway to globalizing China's asset management industry and will expose fund managers to best practices and international standards. Combined with China market expertise and knowhow, this exposure could give China managers a competitive edge.
While mutual recognition is built on the principle of win-win, it certainly does not preclude competition between the asset managers of Hong Kong and China. In certain areas mutual recognition may mean the market will become even more competitive for asset managers, but each side equally will see definite benefits and opportunities.
The question of distribution and service
While the landscape is evolving, distribution channels today are relatively limited in China, with the four largest state-owned banks handling between 60 percent and 70 percent of fund sales. With mutual recognition of their Hong Kong domiciled funds, offshore managers will need to arrange distribution through onshore banks or develop alternate distribution networks. Servicing investors was a key challenge discussed by the participants.
Jed Laskowitz, J.P. Morgan Asset Management, summarized the feelings of all participants in noting, "The ability to support Chinese retail investor diversification into international investments will be a challenge for foreign firms. The distribution model, the relative lack of international investment experience among retail investors, and the maturity of investment platforms and advice are important factors for asset managers to consider."
Across the roundtable participants, there also was general consensus that having an existing joint venture in China could provide an initial advantage for selling to mainland investors, both in terms of distribution support and client servicing. But attendees equally acknowledged the threat of future global competition, noting that the global ambitions of some Chinese asset managers make working with a joint venture partner challenging and could prove a double-edged sword.
"Some Chinese asset management companies could be thinking about opening up in New York, Paris and London, and that is not necessarily what their global asset management partners may have thought about when they formed alliances," noted Hepper.
Dean Chisholm of Invesco additionally noted that if the market becomes like Taiwan in terms of investor appetite, then fund managers will want to take direct control of distribution support and investor servicing—a process that will be much more difficult in China.
However, summarizing the general experiences of the participants, Schroder's Lieven Debruyne talked of a very constructive relationship and being actively engaged with their joint venture partner with respect to mutual recognition. He strongly believes that the joint venture relationship will be a big advantage for them.
Foreign fund managers—implications for new arrivals
Mutual recognition may mean more foreign fund managers are likely to establish a presence in Hong Kong. Not only does a Hong Kong operation potentially give access to China's vast retail market, it also enables fund managers to better serve a growing pool of investors with appetite for direct exposure to the mainland. But how will new arrivals fare against those firms with a longstanding market presence?
BlackRock's Michael Marquardt cited talent as a key challenge: "I think there's going to be a real war for talent in the coming years. People with local languages skills, culture and knowledge are going to be critical to success."
Marquardt questioned how new arrivals without an established reputation in Hong Kong will attract and develop the necessary talent to support selling international products into mainland China. "It's not about starting now," said Marquardt. "It's about having made the investment years ago."
Chisholm agreed, noting that, "Invesco has been on a long road of China opening up. We started around 15 years ago with technical agreements in China and since then have built a lot of relationships with distributors and regulators. New firms wanting to get into China may be late by a couple of decades."
These remarks underscore a longterm view held by all the roundtable attendees. "Mutual recognition is not the end game," according to Schroder's Debruyne. "I think it's just one step in a long process of opening up China toward international capital flows and international management."
A measured approach
This brings to mind the reformer credited with leading China toward a market economy, Deng Xiaoping. He is said to have used the phrase, "crossing the river by feeling the stones," which speaks to maintaining ground on a potentially slippery path through careful steps.
On the path of regulatory reform, China has taken a measured approach to introducing market changes. In contrast to regulatory reform in the West, in China there are no draft regulations circulated, no public consultation periods and no lengthy final documents detailing the law. First there is internal discussion, with consultation and input from the industry. Next there is the introduction of guiding principles that are conceptual. Implementation happens in stages and includes working through any practical issues and questions. Typically there is a test period followed by clarification and a broadening of participation and increased flexibility. Regulations continue to unfold and evolve over time, as seen in a number of areas such as those outlined for Qualified Foreign Institutional Investors (QFII) and Renminbi Qualified Foreign Institutional Investors (RQFII).
For mutual recognition, the significant milestones to date have included:
- Formation of the initial working group in November 2012
- Conclusion in mid-2013 of a sixmonth study of the regulatory framework, involving the mapping of fund regulations in both jurisdictions
- Announcement on December 4, 2013, of the final stretch toward defining the principles of mutual recognition
Current steps underway include developing a working mechanism among the SFC of Hong Kong, the China Securities Regulatory Commission (CSRC) and the State Administration of Foreign Exchange (SAFE) to address outstanding technical issues and determine the scale and eligibility of funds.2
Industry estimates place approximately 120 Hong Kong-domiciled funds as initially appearing most likely to be deemed eligible for consideration for mutual recognition. This is a subset of the 318 SFC-authorized funds domiciled in Hong Kong as of end of June 2013, narrowed by eliminating funds that use derivatives, among other exclusions.3 While details of the fund eligibility criteria are still unknown, roundtable participants had a strong sense that established players—with Hong Kong based fund managers and operations, and local products with a good track record of performance—would be greenlighted first.
Still, attendees expected a slow pace and controlled manner to the implementation of mutual recognition. Laurence Bailey, J.P. Morgan Investor Services, noted: "The size and scale of firms represented in this roundtable discussion means that we can all afford to take bets on a slow-burn strategy."
Feeling the stones—investor appetite, expectations and behavior
The roundtable dialogue reflected the complex interrelationship within the unknowns about investor demand and expectation, initial program restrictions as part of a measured approach and challenges related to operations and tax, among other areas of implementation.
To date, Chinese investors generally have shown a shorter-term investment horizon and prefer lower risk products than their Hong Kong contemporaries. Data indicate that 88 percent stay with a product for less than two years, and 30 percent have an investment horizon of less than one year.4 They also tend to heavily invest in a fund's initial public offerings and trade in and out of funds regularly. This pattern is true of the broader Asian market, where it is common for a fund to raise substantial sums within the first year but material amounts may not remain with the fund for the longer term. It indicates the need for product innovation to satisfy investor performance expectations.5 The participants broadly agreed that longer investment periods in some products have been driven by performance.
It is expected that under mutual recognition, products will start out as plain vanilla—simple and transparent—moving over time toward greater complexity, according to comments from the CSRC and SFC.6 Roundtable members concurred that it is challenging to define plain vanilla and that its meaning must be worked through with regulators during the approval process. But they also wondered what this will mean in light of investor behavior and expectation for returns and how it will affect investor demand.
"Plain vanilla in the eyes of the local population means some sort of China theme," remarked Hepper. "That is the most competitive area in the market but probably not a good starting point for selling international products."
Bailey noted, "There is a balance between relative performance and absolute performance. I think Chinese investors will expect a better absolute performance from their international investments, which can be a challenge with plain vanilla products."
International product demand—QDII as an indicator?
Some attendees questioned whether the QDII program will be an indicator of Chinese investor response to mutual recognition. Under the program, introduced in 2006, Chinese institutions received quotas for cross-border investment in equities and fixed-income products, thereby giving Chinese investors access to international investments. Demand has been tepid over the past five years, with QDII assets totaling RMB 56.2 billion (US$ 9 billion) as of June 2013, a small increase from the RMB 52 billion gathered in 2008, according to research by Cerulli Associates.7
"We've had many discussions over the years as to whether QDII was a success or failure," said J.P. Morgan's Bailey. "Initially the quotas were oversubscribed by multiple times but then later went unfilled. Was it a lack of appetite to invest overseas or was it the vehicle?"
Several attendees attributed the historic low QDII uptake primarily to the unfortunate timing of the initial fund launches that arrived at the height of the market before the global financial crisis. As such, investors suffered the market volatility and investment losses during the global financial crisis, but the roundtable also cited a lack of general investor education and product suitability as contributing factors.
BlackRock's Marquardt emphasized that asset managers share a large responsibility for the successful implementation of mutual recognition. "If we put product out there that doesn't belong, we could hurt ourselves," he said. "This needs to be done in the right way for the long-term benefit of the investor. That will be the best thing for the industry."
According to Simon Lopez of AXA Investment Managers, "The reputational impact of pushing unsuitable products is immense. We remain conscious of this and, accordingly, are adopting a prudent approach."
"It's important that asset managers think very carefully about the types of products they launch into China," agreed Laskowitz. "The QDII experience proved that retail investors can be too euphoric when markets are performing well and should be more focused on asset allocation, diversification and long-term investing."
Hepper noted the recent traction under QDII by a number of foreign banks in selling international products to high net worth individuals under very restricted licensing arrangements. In his view this could be a leading indicator of the increasing popularity of international funds among this client segment as well as retail investors.
Additional operational and tax complexities
Against this backdrop of uncertainty, Hong Kong's fund industry faces additional practical challenges to implementation.
Hong Kong funds selling into China will no doubt be subject to a quota, while industry participants speculate as to whether the quota will apply at the fund or manager level. Even with a quota, scaling to the potential demand of Chinese investors is a concern for Hong Kong, where transfer agents operate wholesale omnibus positions largely manually by fax in contrast with mainland China's retail positions operating through highly automated fund order processing.
To illustrate the concern, the roundtable group discussed a hypothetical case of a US$ 500 million fund that was to double its size by receiving a US$ 500 million quota. If successful in a short period, the wave of transaction volume could overwhelm a Hong Kong transfer agent. The problem would be exacerbated if a subset of investors exhibited a high churn rate associated with a short-term investment horizon.
It's a key question for the industry in how to reconcile fund processing and record keeping differences for crossborder investments. China's transfer agents maintain fund records down to the individual investor level, often running into the millions, while Hong Kong banks in contrast primarily use omnibus account structures in a distributor's name.
In addition to the operational issues associated with this transactional scale difference, the transfer agents will also be greatly impacted by the due diligence processes for anti-money laundering (AML) and know your customer (KYC) rules. "Chinese banks have their own procedures for AML, KYC and other controls--and these may not consistently meet global standards," pointed out J.P. Morgan's Laskowitz.
The discussion also touched on the relative privacy afforded to clients by an omnibus structure. The general view was that it will have to be seen whether, when it comes to Chinese retail investments into Hong Kong internationally invested funds, the Chinese regulators would like to maintain the transparency that currently exists in respect to ownership.
Several participants noted that longstanding tax questions have impacted earlier initiatives, specifically the capital gains tax obligations for QFII and RQFII. Said Invesco's Chisholm, "The current tax set-up under QFII and the RQFII is not ideal. As the products evolve, you close some and open others. But you can't close a product that has a large outstanding tax liability."
J.P. Morgan's Hepper added, "I think many people have been trying to fix these tax issues for years. Mutual recognition could be the catalyst for the Chinese regulators to clarify the outstanding questions and in doing so remove one of the main obstacles to investment into China."
Industry groups such as HKIFA and ICI Global, which have mutual recognition task forces, have been raising their members' concerns with the regulators primarily through the Hong Kong SFC. "The one thing you can be sure of is that all of the issues we're talking about here are known to the regulators," said Debruyne, who is also HKIFA's chairman.
Broader repercussions and future possibilities
Mutual recognition extends the RMB as an investment currency, which—along with becoming a trade settlement and reserve currency—is key for its journey toward internationalization. Roundtable participants discussed the potential impact of improved market access and RMB convertibility, including the likelihood of MSCI and FTSE opening their indices to a much larger China component.
Noted J.P. Morgan's Hepper, "As soon as the index makers believe there is unrestricted access to China markets and the renminbi, which we're gradually moving toward, it will go into the indices and global money will be pouring into China in a big way."
Patrick O'Connor, fund services product manager for J.P. Morgan Investor Services, added: "A shift in weighting represents hundreds of billions of dollars in assets across managers that follow the indices either directly or indirectly."
It also could help further propel Hong Kong as an offshore RMB wealth management center and international asset management hub. There has been a huge buildup of RMB balances in Hong Kong alongside growing investor appetite for RMB investment products.
Mutual recognition—a stepping stone toward a regional marketplace
Mutual recognition is technically not a funds passport system, whereby funds authorized in one jurisdiction automatically may be sold in another. It has been referred to as more of a visa than a passport, enabling streamlined access to entry in the different markets but not automatic access. However, a number of initiatives are underway within the region to support the crossborder distribution of Asia-based funds. Regulators announced three separate Asian funds passport schemes last summer.8 Many believe, including the roundtable participants, that mutual recognition holds the most immediate promise among emerging initiatives, potentially giving Hong Kong a relative competitive edge compared to Asia's other financial centers.
Eventual expansion of the mutual recognition scheme to a Greater China passport that includes Taiwan is widely anticipated. According to an EY report, the initiative more broadly could spur other mutual recognition platforms between China and individual or groups of countries within Asia Pacific. This in turn could catalyze a regional funds industry, with size and liquidity to work, based on a network of mutual recognition platforms that eventually could form a fund passport platform with unified investment fund authorization across the region like UCITS.9
While the political will around these broad initiatives appears present, there remain a significant number of practical issues to be addressed—hence the industry's view that the Hong Kong/ China mutual recognition is most likely to bear fruit first.
Mutual recognition beyond Asia
Shortly following December's roundtable and somewhat surprisingly to many in the industry, press reports indicated a possible mutual recognition agreement between China and the UK as early as next June, which would ultimately eliminate the need for UK-based managers to domicile their funds in Hong Kong and temper Hong Kong's advantage.10
In response to these reports and in conjunction with the points put forward in the roundtable, Andrew Lawson, global custody product manager for J.P. Morgan Investor Services, noted: "As with the RQFII program, Hong Kong will be the first stop for mutual recognition but it is unlikely to be the last. While the timing of expansion and the order of countries is unknown, the general market sentiment is that the approval of Hong Kong funds will take some time, and actual cash flows into Hong Kong from mainland China will not likely occur before Q3 or Q4 2014."
The dominant view is that the rollout of the mutual recognition scheme between Hong Kong and China will be undertaken gradually through 2014 and beyond. "Should we accept this belief, the view that Taiwan and a Greater China recognition scheme will be next, and if they follow a similar process and timeframe, then it could be quite some time before the UK or any other jurisdictions find their funds on the shelves of Chinese distributors," said Lawson.
Gaining momentum in the year of the horse
While the timetable for implementation remains unknown, roundtable participants all agreed that the process for mutual recognition will advance materially in 2014. Attendees felt that the next significant announcement could occur as early as the end of January, coinciding with Chinese New Year.
It's said that in the astrological year of the horse, the horse is tasked with taking humankind forward and preparing for the future. It should be no surprise if this year brings decisive action to propel momentum for the further integration of Hong Kong and mainland China's funds management industry.
1 "Fund Managers: ... but some say the scheme will disappoint," Asian Investor, October 1, 2013, www.asianinvestor.net
2 Hui Ching-hoo, "Hong Kong and China reach guiding principles on mutual recognition," Asia Asset Management, December 6, 2013, www. asiaasset.com .
3 Kylie Wong, "Few HK fund firms ready for mutual recognition," Ignites Asia, December 11, 2013, www.ignitesasia.com .
4 Shannen Wong, "Investors in China: short-term thinking, low risk," Ignites Asia, December 6, 2013, www.ignitesasia.com .
5 John Sedgwick, "Product innovators, first movers critical in Asia," Ignites Asia, December 10, 2013, www.ignitesasia.com .
7 Ellen Kelleher, "Demand for Chinese QDII funds 'feeble'," Financial Times, September 29, 2013, www.ft.com .
8 Jame DiBiasio, "Fund Managers: Tapping into the Asia story," Asian Investor, November 1, 2013, www.asianinvestor.net .
9 Ernst & Young China, "Hong Kong—the major fund domicile of the future?" August 6, 2013, www.ey.com .
10 Paul J. Davies, "UK funds close in on China access deal to rival Hong Kong," Financial Times, December 22, 2013, www.ft.com .