Winter 2012

ETFs: A second chance

IndicesChina’s second renminbi qualified foreign institutional investor programme involving exchange traded funds is growing – quotas are being increased and more asset managers are lining up to participate. Stefanie Eschenbacher investigates.

More renminbi-denominated exchange traded funds (ETFs) tracking China’s physical A-shares are waiting for regulatory approval, after the last one of the first batch listed on the Hong Kong Stock Exchange in November.

China Asset Management Company, CSOP Asset Management, E Fund Management and Harvest Global Investments – have already successfully launched an ETF under the renminbi qualified institutional investor (RQFII) scheme.

At least another four asset managers are to follow suit and the China Securities Regulatory Commission is expected to make a decision early next year.

Several industry experts in Hong Kong have highlighted Bosera Asset Management, China Universal Asset Management, Da Cheng International Asset Management and Hua An Asset Management as the most likely candidates.

Victor Lau, a sales director at Da Cheng International, confirmed that it was being considered as a potential candidate. A spokesperson for Bosera Asset Management says a couple of Chinese asset managers are preparing product applications.

China Universal Asset Management and Hua An Asset Management neither confirmed nor denied plans. The regulator itself was unavailable for comment.

Under the scheme, asset managers are granted a quota by Chinese authorities. Their RQFII ETFs then aim to track the performance of an A-shares index by channelling the renminbi raised outside of China to invest directly into a portfolio of A-shares.

Hong Kong alone has accumulated deposits of 552.3 billion renminbi ($88.6 billion) while Singapore has 60 billion renminbi and London 109 billion renminbi.

Cindy Qu, analyst at Shanghai-based consultancy Z-Ben Advisors, says some RQFII asset managers have started to raise renminbi in both London and Singapore in an attempt to build a greater institutional network at international level. “Institutional investors prefer access to renminbi in foreign markets to invest in Hong Kong-specific products,” she says.

“Extending their fund raising efforts beyond Greater China not only allows Chinese managers to build a global presence, but also furthers the internationalisation of the renminbi.”

The internationalisation of the renminbi has accelerated since the financial crisis, although the Chinese government has not publicly stated its goal or what monetary system it plans to achieve.

Nevertheless, its various schemes to facilitate cross-border trade have created opportunities for asset managers and investors alike.

This RQFII ETF programme has so far avoided the pitfalls of the RQFII programme involving bond funds. At least 80% had to be invested in bonds, leading to almost identical products.

Hong Kong’s Securities and Futures Commission had approved 18 RQFII funds in 19 days – at the fastest rate ever – and a total of 21 asset managers were granted a quota.

Too much supply and not enough demand meant only a handful of these had been fully subscribed to within weeks of their launch. Most asset managers struggled to fill their quota and interest in these funds only picked up as the market turned, making bonds generally more attractive.

The second RQFII programme, however, was different. Only nine asset managers were invited by the regulator to participate and asked to present their concept, but the final decisions were made behind closed doors.

RIGOROUS
To outsiders, the only known conditions are that they must have done well in the first round of RQFII funds and have experience in managing ETFs.

A source close to the matter, who declined to be named, says some departures from the scheme left other participants puzzled.

The source also says several asset managers were bidding for the CSI 300 Index at first, but it was awarded to China Asset Management as compensation for having had a competitive disadvantage in China. In 2010 it could not launch any domestic funds because of shareholder restructuring issues so the CSI 300 Index was allegedly given to the asset manager to make up for lost business.

Freddie Chen, managing director, declines to comment on behalf of the regulator. Instead, he points to the success China Asset Management Company had managing similar products in China.

After what the asset managers describe as a rigorous selection process four were selected to launch an RQFII ETF. An index could only be licensed once and the ETFs had to launch at different times.

Jackie Choy, ETF strategist at Morningstar Asia, says the response from investors has so far been encouraging. “One advantage these ETF providers have is that they invest directly into the A-shares market, not via derivatives,” he says.

Quotas sold within weeks of the launch. China Asset Management Company saw its quota then raised to 8 billion renminbi, CSOP Asset Management to 10 billion renminbi, E Fund Management to 5 billion renminbi and Harvest Global Investments to 5 billion renminbi.

Z-Ben Advisors reported “massive” redemptions in some of these ETFs in November, most notably the product from Harvest Global Investments, highlighting the turmoil seen in the A-shares market and speculation from institutional investors as possible causes.

However, applications for new quotas are already being prepared as demand from Hong Kong is increasing.

The fact that these RQFII ETFs are subject to quotas could become problematic in case the quota is reached and an additional quota is not granted – or not in time. Choy says unit creations could be disrupted and the ETF could trade at a premium as a result.

Choy adds that there is also a 10% intra-day trading band for ordinary stocks while stocks traded on the Hong Kong Stock Exchange, including the RQFII ETFs, are not constrained by such a limit.

“If and when A-shares are constituents of these ETF benchmark indices reach these limits, it will likely result in premiums or discounts between the ETF’s market price and it’s net asset value,” he says.

Being denominated in renminbi – a currency that is not freely tradable – means investors also have to have sufficient deposits to trade RQFII ETFs. Retail investors, for example, can only exchange 20,000 renminbi per day.

Choy also points to different accounting treatments of potential capital gains taxes on A-shares – qualified foreign institutional investors may face a 10% withholding tax on gains they make from selling A-shares, although this has only been enforced on dividend and interest payments from stocks listed in China so far.

Despite these challenges and the fact that China has had the worst-performing major stockmarket in Asia this year, these RQFII ETFs have, so far, been popular with investors.

DIVERSIFICATION
Qu says investors interested in RQFII products are those that have obtained little China exposure and wish to diversify away from market instability in Europe and North America.

“Chinese asset managers must target institutional investors that have not invested in obtaining QFII licenses and must instead rely on Chinese managers for market entry by proxy, albeit through mainland-tagged products in Hong Kong,” Qu says.

Choy adds: “Diversification is something that investors should do to enhance investment returns and to reduce risk. These RQFII ETFs have a low correlation with the rest of the world, particularly Hong Kong.”

The key performance driver is likely going to be the financials sector. The FTSE China A50 Index, for example, has 61.8% invested in financials, twice as much as the MSCI China A Index.

Choy says investors who are anticipating a rebound in the Chinese economy should consider an ETF tracking one of the broader indices, with a greater number of constituent stocks.

The CSI 300 and the MSCI China A Index are less exposed to the financial sector and more broadly represent the composition of the Chinese economy.

Peng Wah Choy is chief executive officer of Harvest Global Investments, the latest Chinese asset manager to list its Harvest MSCI China A Index ETF. “We took longer because we wanted to offer the dual counter – for technical or regulatory reasons some investors may not want the renminbi exposure,” he says.

The Harvest MSCI China A Index ETF was the first one to add a dual counter that offers investors two trading counters on the Stock Exchange in Hong Kong – in renminbi and Hong Kong dollar. Meanwhile, all four asset managers have added this to their funds.

Choy says the MSCI China A was the better choice in the end because it allows investors to participate in growth in sectors such as health care and information technology.

“The MSCI China A is the largest and most diversified of the four indices; it gives access to sectors that are not included in the rest,” he says.

“It has two major benefits because it has a wider coverage than the more concentrated indices and sector allocation is more diversified,” he says. “When people talk about China’s economic story, they talk less about financials – but more about health care, consumer staples and consumer discretionary.”

On the other end of the spectrum, an RQFII ETF tracks the China A 50 Index.

Chen Ding, chief executive officer, says CSOP Asset Management’s  parent company, China Southern, sells ETFs tracking the CSI 300 and CSI 500, respectively, to retail investors in China.

“That is different,” she says. “Domestic clients understand the market better, but global investors want to have the largest companies first when they invest in emerging markets.

ETFs tableWe mainly target overseas investors and the China A 50 Index is the most recognised China A-shares global index,” says Ding of the CSOP FTSE China A 50 ETF.

Other factors that influenced the index choice, she adds, were that its futures are traded in Singapore while warrants and options are traded in Hong Kong.

Chen also says one of the reasons for choosing the CSI 300 Index was because it is the only one available for index futures in China.

Nathan Lin, managing director of E Fund Management in Hong Kong, says the CSI 100 Index is operationally less challenging. It launched the E Fund CSI 100 A-Share Index ETF.

“These [companies] are not necessarily the fastest growing, but there is growth potential and liquidity,” Lin says.

“As Asian markets did not perform well, it is hard to sell active funds. In fact, it is very hard to sell any Asian fund.”

DIFFERENCES
Morningstar’s performance analysis shows that indices with fewer constituent stocks have outperformed over the trailing twelve months, but have underperformed over the past three years. This is likely to be attributed to the performance in the financial sector.

There are no particular trends or significant differences worth noting when it comes to standard deviation, according to the analysis. Though indices with a greater number of constituents usually include small and mid cap stocks.

These could be less liquid and potentially result in a greater tracking error relative to those tracking indices with fewer, larger constituents.

An earlier study by Morningstar suggests that in fact the total expense ratio is the most reliable predictor of future success.

©2012 funds global asia

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