With little fanfare, a potential opportunity for ETFs in China was recently announced.
In August, the CSRC (China Securities Regulatory Commission) and Hong Kong SFC (Securities and Futures Commission) announced that the long-delayed Shenzhen-Hong Kong Stock Connect is officially set to move forward in November. Originally proposed in 2015, the Shenzhen-Hong Kong Stock Connect is modeled on the Shanghai-Hong Kong Stock Connect, which was launched in 2014 and allows for mutual access between the two stock exchanges.
Most of the commentary has focused on the implications the Shenzhen-Hong Kong Stock Connect will have on China’s ambitions to have A shares added to the MSCI’s Emerging Market Indices. While this is undoubtedly a key reason for its launch, there is another aspect to the announcement that may be of more interest to asset managers: ETFs will be considered eligible securities under the new program.
Currently the main way to access Mainland investors is through the nascent MRF (Mutual Recognition of Funds) program. The MRF allows, subject to certain conditions, Hong Kong funds to be sold into Mainland China and for Mainland funds to be sold into Hong Kong. The inclusion of ETFs in the Shenzhen-Hong Kong Stock Connect opens up another route to Mainland China investors, which is sort of an El Dorado for asset managers.
ETFs will be included in the Shenzhen-Hong Kong Stock Connect after it “has been in operation for a period of time and upon the satisfaction of relevant conditions,” as the CRSC put it. There is no additional detail on exactly how it will work, but as asset managers assess the opportunity, there are three key questions that are front of mind.
Which type of ETFs will be allowed?
Using the MRF program as a guide, it seems likely that there will be restrictions on the ETFs that will be eligible, at least from the outset. Under MRF, the eligible funds are limited to basic equity, bond, mixed funds (bonds and equity), along with physical index-tracking ETFs. It stands to reason that similar requirements will be put in place; so, for example, it’s unlikely that synthetic leveraged inverse oil ETFs will be eligible for the Shenzhen-Hong Kong Stock Connect anytime soon.
Will there be any quota restrictions?
A key aspect of the Shenzhen-Hong Kong Stock Connect announcements was that there will be no quotas associated with the program. Unlike the MRF passport schemes, there will be not be a quota associated with the Shenzhen Hong Kong Stock Connect, meaning Hong Kong or Mainland investors will not have restrictions on how much they can trade. The quota is one of the key limitations of the MRF program because investors from the host country may not exceed 50% of the fund’s total assets. This caps the amount of money that a Hong Kong funds can attract from Mainland investors to half of the fund’s total net assets. If the Shenzhen-Hong Kong Stock Connect lack of quota extends to ETFs, it could be major boon to the industry.
Will there be any domiciliation requirements on the ETFs or managers?
Under the MRF program, funds must be domiciled in Hong Kong to access Mainland investors. The funds must be authorized for more than one year and have a minimum of RMB 200 million in assets to be eligible. Additionally, there are substance requirements for the asset manager with a physical presence in Hong Kong.
Some in the industry have suggested that the Shenzhen-Hong Kong Stock Connect may allow managers to circumvent these rules. The idea is that managers may able to list a European UCITS ETF on the Hong Kong Exchange and then distribute the ETF to Mainland investors via the Shenzhen-Hong Kong Stock Connect. However, as tempting as this idea sounds, it is unlikely to play out this way.
Both the Mainland and Hong Kong policymakers seek to develop a local asset management industry and establish Hong Kong as a global fund center. Given this, it seems unlikely that policymakers would allow EU funds in through the backdoor and undermine their larger policy goals. It is far more likely that only Hong Kong-domiciled ETFs will be allowed to be sold to Mainland investors through the Shenzhen-Hong Kong Stock Connect.
At the moment, there are more questions than answers about how ETFs will work on the Shenzhen-Hong Kong Stock Connect. If the program does move forward, it could be a great way for asset managers to access investors in Mainland China and should expand the range of investment opportunities for Mainland investors beyond the 200 ETFs that are currently available in Hong Kong. The Shenzhen-Hong Kong Stock Connect is definitely something for managers to keep an eye on as it could be a critical piece of Hong Kong’s plan to establish itself as a global fund center.