Opportunity Knocks – China Calls to Global Asset Managers

While industry chatter is focused on the recent inclusion of China A-shares in MSCI indices, there are several equally exciting opportunities ahead for global asset managers looking to invest in or access capital in Mainland China.

For some time now, China has been accelerating the opening of its capital markets and promoting cross-border capital flows. However, technical and regulatory matters stood in the way before a truly open market could come to fruition. Now, activity in China and Hong Kong is opening doors for global asset managers itching to gain access to the fastest growing economy in the world. Optionality is the name of the game when it comes to accessing the Mainland economy – we’ve highlighted four investment and distribution opportunities global asset managers should have on their radar.

QDII: Hundred Billion Dollar Milestone

Access to the Mainland equity and bond markets has never been more readily available and Chinese regulators continue to take big strides to support increases in capital outflows. Their recent instrument for this expansion is the Qualified Domestic Institutional Investor (QDII) scheme. QDII allows Chinese financial institutions to invest in foreign securities markets under a quota system. After a three-year hiatus, China’s State Administration of Foreign Exchange (SAFE) issued new quotas in two consecutive months, beginning in April this year. In May, SAFE granted new quotas of US$3.17 billion to eight new recipients, bringing the total QDII quota through the $100 billion barrier for the first time. This means 152 Chinese financial institutions now have the opportunity to participate in offshore investment.

Historically, investment via QDII has stayed close to home with a focus on offshore Chinese companies. Many QDII quota holders also invest in other mutual funds domiciled outside of China to access investment expertise that may not be available in house. As a result, global asset managers are enthusiastic about the new quota as Chinese institutions look to deploy that quota offshore into products like ETFs and UCITS funds.

ETF inclusion in China/Hong Kong Stock Connect

Another exciting opportunity is the inclusion of ETFs in the existing linkage between the China and Hong Kong Stock Exchanges for “ETF Connect” – a cross-border plan allowing Mainland investors to invest in overseas assets through ETFs listed in Hong Kong, and for international investors to access ETFs listed in the Mainland. The ETF Connect plan once more underlines Hong Kong’s ambition to act as a conduit for Mainland capital. It comes on the heels of the successful launches of both the Stock Connect and Bond Connect schemes, but ETF Connect will offer investors exposure opportunities to a more diverse range of assets. According to our recent survey of professional ETF investors, almost 90 percent of Mainland China respondents said they plan to invest in Hong Kong ETFs after ETF Connect is launched.

ETF issuers in the region are eagerly awaiting the announcement from the Mainland and Hong Kong regulators detailing requirements for the program, including how closely the rules will follow Mutual Recognition of Funds (MRF). In the interim, Hong Kong ETF issuers are actively reviewing their product lineups and working to better understand investment demand from Mainland investors. Based on our survey data, Asia Pacific equity ETFs were the top asset class Mainland investors are looking to access through the program.

Owing to the strict capital controls in China, there is pent-up demand from Chinese investors for global diversification. We expect regulators will announce ETF Connect before the end of 2018.

The Hong Kong OFC is almost here

We have previously flagged the importance of a corporate fund structure as part of the Hong Kong toolkit, particularly to enable such vehicles to be sold on a cross-border basis. After much anticipation and deliberation, in May, the Securities and Futures Commission (SFC) released their consultation conclusions setting out the final rules and codes for Open-Ended fund Companies (OFCs). These include streamlining the approval requirements and setting out a one-stop arrangement for the establishment and termination of OFCs.

This development allows for investment funds to be established in corporate form in Hong Kong, in addition to the current unit trust form. The primary benefits of this new structure are the ease of cross-border activity as well as providing certainty on segregation of liability between sub-funds. The OFC rules are subject to further legislative approvals, but we expect that the OFC regime will come into effect on 30 July 2018. The expectation is that the OFC would follow the same protocols for eligibility to distribute to Mainland investors through the MRF program.

China A-shares added to MSCI Indices

Finally, MSCI made the widely anticipated decision last June to include China A-shares in its Emerging Markets Index starting this month. Initially, MSCI has added 230 large-cap stocks to the index through a two-step inclusion process (effective June 1 and September 3).

After the two-step inclusion, China A-shares will represent 0.8% of the index, however the industry expects that their inclusion will represent initial inflows of foreign capital of US$20 billion, as a substantial number of passive funds and ETFs will automatically rebalance portfolios to match the index adjustment. In time, if MSCI includes all A-shares in index weightings for the MSCI’s Emerging Markets Index, the industry estimates about US$300 billion would be allocated to the Mainland stocks.

But this change is more significant than the numbers. It represents the most tangible development in the liberalization of ownership of Chinese stocks. The initial inclusions are just the beginning and we expect to see Chinese firms with significant weightings in more globally diverse indices in the future.

The Time is Now

For asset managers without a China strategy or still formulating one based on the fast-evolving regional developments, the time for action is now. Managers should consider whether a Hong Kong domiciled fund or a Hong Kong-listed ETF would make a valuable addition to their global product suite or whether other China investment or investor access opportunities are worth exploration. While it will not be appropriate for everyone, such strategy warrants closer consideration. These Mainland initiatives affirm the infinite future opportunity for asset managers to drive their China strategy.

This article was contributed by BBH Senior Vice President Chris Pigott.