The investment fund industry in Asia is nascent.
In China, the business is expected to triple in the next three years. Which means, in 2015, that the business will reach $1.1 trillion in assets, according to Z-Ben Advisors. That is about the size of the exchange-traded fund business alone, in the United States.
Z-Ben believes that the four biggest foreign banks in China are about to be given the ability to create and market mutual funds.
But there is no part of the world with greater immediate growth prospects.
According to the IMF, China’s economy grew 9.2% in 2011 and is projected at 8.4% this year and 8.65% next year.
By comparison, advanced economies are projected to grow at 1.4% this year and 1.9% in 2013.
So how do mutual fund operators and ETF operators get a foothold in Asia, in particular China, if they get started as soon as they read this article?
Philip, do you want to start?
Philip Lin, Director, North Asia, Investment Services, T. Rowe Price: What has worked for us is to focus on pursuing the institutional opportunities directly from the U.S.
Now, we also have offices in Hong Kong and Singapore, and we have been taking advantage of those offices and trying to establish our Hong Kong office as a hub for Asia-based clients. But we do not have a local office within mainland China yet.
And we have been fairly successful in pursuing this strategy. Several distinguished Chinese institutional investors, primarily the sovereign wealth funds, the national pension funds, have been issuing requests for proposals and hiring external managers to outsource part of their assets, and we have been actively participating in these opportunities.
Right now, there is no prerequisite that you have to have a local presence in order to win mandates from these institutional investors. Whether that's going to continue to be the case remains to be seen.
MME: What else?
LIN: There is another segment within the asset management industry that you can also consider participating in as a foreign asset manager. That is the QDII program.
MME: Explain that.
LIN: QDII stands for Qualified Domestic Institutional Investor. What happens is that they allow the domestic qualified fund houses, banks, insurance companies, to manufacture products that will allow Chinese local retail investors to invest overseas. And because they have a tight control over the conversion between (Chinese) renminbi and foreign currencies, the only way the Chinese retail investors now can invest their RMB money into overseas markets is through the QDII.
MME: How can American fund companies operate under this program?
LIN: There are two options. One option is that you find a local partner. With respect to that, there are two ways you can participate.
One is you establish a JV, you find a JV partner, or you can do it through equity participation. You can be a shareholder of an existing fund house or bank or other QDIIs.
The other option is that you can be hired as an advisor to a QDII, to an existing Chinese domestic fund house or bank or other QDIIs.
Under this option, the Chinese QDII will basically outsource the investment or advisory management business to the foreign asset manager.
MME: And you get a fee for being the advisor.
LIN: That's correct. Then you earn a management fee for being an advisor. A discretionary advisor.
Peng Chen, CEO, Dimensional Fund Advisors, Asia (ex Japan): Very similarly, in the QDII program, you can get hired by an insurance company, or by a bank, or by a brokerage house here in the United States, to subadvise part of their money.
So in that sense you are leveraging their distribution.
And so it is quite natural for that combination, because in China, most of these banks and security houses and so on and so forth, don't really have expertise managing money outside of the U.S. What they do have is distribution inside China.
They have a large individual investor base, a lot of wealth being created, as you pointed out. So it is natural for them to reach out to firms that have that kind of expertise.
So predominantly foreign domiciled asset management firms can act as subadvisors. They are saying, "Hey, we have brought in some experienced asset managers to subadvise this."
MME: Is this the fastest way to get going, because you can have a contractual arrangement?
LIN: Yes. Correct.
But the current trend appears to be that the fund houses, which are the major players in this QDII business, are less and less willing to outsource a mandate on a totally discretionary basis.
MME: Because they feel they are getting better at it themselves?
MME: You are teaching them basically how to do it?
LIN: Well, the original idea from the CSRC, which is China's equivalent of our SEC, is to encourage the local fund houses to hire foreign asset managers who are experienced in managing overseas assets. Through this cooperation, the local QDIIs can learn how to invest overseas and then do it on their own.
MME: That happened with digital electronics, too.
LIN: What happened is right after the launch of the QDII program in 2007, we ran into the 2008 financial crisis. There were a lot of layoffs on Wall Street and in our financial sector, and that provided a good timing for the Chinese financial institutions to hire Chinese nationals who speak Chinese, who are familiar with China's culture, but who have worked here, as a portfolio manager, analyst, whatever. They cherry picked, and they matched the salary of Wall Street.
They hired a lot of experienced Chinese nationals who have worked on Wall Street or in the asset management industry to be their own portfolio managers for their own QDI product.
MME: So how do you set up now?
Benjamin Poor, Manager, Market Intelligence Securities and Fund Services, Citi: Asset managers have to define what "Asia" means. You can't really have an "Asia" strategy. Look at how fragmented Europe is, and yet, Europe has a common currency, a common political union, and a common fund passport in UCITS. And geographically, it's fairly compact. You look at Asia, and basically, you have none of these things going in your favor. You don't have common currency, you don't have a regional fund passport, and you have differences in how the retail markets are shaped.
Tim Barron, CIO, Segal Rogerscasey: You have different cultures that are actually embattled. Over islands and everything else. Asia is just not anywhere close to being cohesive. Rules are different in every market. Growth rates are different in every market.
LIN: Regulatory schemes are also very different.
LIN: I cover North Asia excluding Japan, which includes mainland China, Hong Kong, Taiwan, and Korea. Each of them has a very distinctively different legal system. So it may look like, well, you lump them together, but, actually, they are four very separate, very different areas for you to develop business.
BARRON: Exactly right. Which means you have to develop a plan. You have to decide who you are and how your services and capabilities fit within individual markets.
MME: You can't have one strategy.
LIN: No. You have to really figure out what Asia means to you. You have all these very attractive statistics, high growth rate, all this money. But what is the concrete benefit to you? Can you really realize these benefits? When you get into the nitty gritty of those things, it may totally change your mind. You may decide not to go in at all. Or you need to be patient, you need to figure out, really, a different strategy for different areas.
CHEN: It depends on, at the end of the day, what are your strengths, and what you do with them. Some will be happy to just work with the institutional business. Being subadvisors, working with the institutional investors. Some will try to focus on getting a JV set up to attack the individual investor market. Some may want to have a better infrastructure in terms of trading in the region to support their global operations.
I don't think a true global asset manager can ignore it, but at the same time, it doesn't mean that you have one set of strategies or one winning formula for Asia, or for China, for that matter.
MME: Dimensional is based in Austin, Texas. How do you go about getting your foothold?
CHEN: Dimensional was founded by David Booth back 30 years ago, following what we call the science of investing, of academic research. Our approach has been long term investing, to be patient, and to add value through getting exposed to higher expected return assets, and through trading and operational efficiency.
We have attracted a lot of clients and have more than $200 billion in assets under management.
In Asia, we have four things we would like to achieve over time. The first one is to try to address the institutional investors market. They want better returns, better investment outcomes, and less risk. Serving institutional investors subjects foreign managers to less regulation than if they target retail investors. Institutions can go out and hire foreign asset managers for mandates today.
MME: Are the corporate funds looking for faster returns? What is different about the corporate funds?
LIN: If we are talking about China, the corporate funds are not allowed to invest overseas yet.
In many cases, their investment is governed or instructed by the state. The government will tell you how you use your assets. A lot of enterprises and corporations are state owned.
CHEN: That's certainly the short term challenge in China. But there is no denying that beyond the sovereign wealth fund, certain large corporations have a lot of cash and wealth. So these are emerging.
LIN: The competition is also very severe.
MME: Where does the competition come from?
LIN: The global asset managers.
MME: Everybody wants in.
LIN: Everybody. And local financial institutions are getting more and more sophisticated in selecting managers. They are fast learners. They use consultants. They also rely more and more on their own internal database to search for managers.
POOR: Yes. The Chinese National Social Security Fund announced in July that it is looking for 13 mandates to award to foreign managers. There's an example of a demand for global managers, and in some cases (these are) specializing in alternatives. Could be a hedge fund, could be real estate. And, by the way, this flow is really going on both ways. CalPERS is going to invest $500 million in real estate strategies in China.
What's going on in the institutional market in China might not mirror what's going on in the U.S. and Western Europe, but you could say it rhymes.
CHEN: The second piece (for Dimensional) is the retail side of the market, which is much more challenging because there you are distributing to an audience that has an investment philosophy much more in tune to a trading culture or mentality. Also, the distribution is controlled by large banks and security houses that are heavily based on commission and revenue share. Plus, to manufacture local funds, particularly in China, you need to have a local presence. Not just a local presence, but a regulated entity. The only way to do that is through a JV or, like Philip suggested, buy a share (of equity of a local fund house) to participate.
MME: If you have a long term hold strategy for a mutual fund, that is not something that the retail investor in China may be used to, comfortable with, or really even understand.
CHEN: Correct. So there's very much a need for, what I would call, the financial intermediaries, just like in the US. There are only so many individual investors that are willing and able to learn the science of investing. Most of them will just say, "Hey, I trust Tim. I trust Ben. I trust Philip. Let them do it."
MME: They are going by the guts of people they know.
CHEN: That's right. So that's much more challenging and long term.
The third piece is building off a global infrastructure. Having a foot on the ground, at least from Dimensional's perspective, helps tremendously when we execute our trades, when we select stocks, and so on and so forth.
And that doesn't have anything to do with China's institutional investors, nor anything to do with the retail investor.
The fourth thing, which is probably also very exciting and I haven't seen a lot of people mentioning, is that as the Asian economy grows, allocations need to grow. If you look at your 401(K) portfolio, if you look at your brokerage account, right now you may have a 5 percent allocation to that region. That's going to significantly increase. Just like 20, 30 years ago, we allocated a very small portion to Japan, to Europe.
POOR: China itself is going to become an asset class separate and distinct from the rest of the BRICs [Brazil, Russia, India and China]. If you look globally right now, China, in terms of market cap or in terms of GDP, represents roughly 10 percent, give or take, of the globe. And yet if you look at global investors' allocation to Chinese equities, it is on the order of .1 percent.
BARRON: I personally am not so sure that China becomes an asset class in and of itself. Japan was, and then it wasn't. I am confident, however, that US investors particularly will be less Amerocentric and will look to Asia as a significant part of their asset pool going forward.
MME: How do you work on the asset allocation part?
BARRON: Our clients are institutional investors, principally from the U.S., as well as high net worth individuals. In fact, some of our capabilities get to the retail level. One, Peng said globalization and the impact of globalization for US based, European based investors, and, ultimately, Asian based investors is going to be dramatic going forward. We have been saying this for 20 years, 30 years, but it really seems as though now the momentum behind that is much stronger than it ever has been before. Consider the notion that you are looking at your 401(K) statement and noting that you didn't participate in the opportunities in the growth of Asia. Ten years from now if you had not participated, I think you would have missed a big part of the returns generated during that decade.
Beyond this, I am convinced there will be a development of a full fledged wealth advisory business. This will be part of China and be part of Asia going forward. It just doesn't exist now.
BARRON: So one of the things asset managers have to do if they are going to be in that market is they have to be developing new hot products for this kind of churn mentality.
MME: And a hot product exactly is what?
CHEN: So to give you a quick example, last year one of the hot products was gold. Gold went up. In the United States, when you launch, you have a small asset base, and you start to get your message out, you have a track record, and it starts to gradually build up. Over there, oftentimes you launch it, that's the day you are going to have the biggest asset base and it steadily declines. Because that's the hot product at that moment, everybody buys in, and then as things wear off, other hot products come onto the market.
BARRON: Very IPO, Facebook esque.
LIN: People investing in mutual funds have the same mentality as investing in stocks. It is like that of a day trader.
BARRON: If you are trying to enter that business, think of the expense that's associated with having to continually develop product.
CHEN: That being said, it is also a tremendous opportunity to think long term, if you get your message right. Because there are academic studies showing that this type of short-term trading behavior takes out 3 to 4 percentages a year from the performance, compared to a simple disciplined asset allocation buy and hold strategy.
MME: It's a very interesting aspect here. So if T. Rowe Price or somebody else is going to set up a full fledged shop here and really work this market, how many hot products do you have to produce a year to be successful?
CHEN: I would say, Tom, actually, before you ask how many hot products, I would say from an asset manager's perspective, you should ask yourself do you even want to be in this game.
MME: IF you are going to go through all that pain, what are the main pain points you are going to have to deal with?
LIN: Now, there are advantages and disadvantages for each of the JV and equity participation options.
With a JV, you normally can exert more control from the outset to try to integrate your own culture with the local partner's culture.
If you do equity participation in an existing company that has developed a strong brand and culture, then first of all, you probably won't get much of a share because there are other shareholders and they may not want to sell their shares; unless if that company is not doing well, in which case you may not want to participate to begin with. Accordingly, it may be much harder to integrate the different cultures through the equity participation option.
With a JV, you have to be more patient and be ready to invest upfront without any return for three or five years. You have to have that kind of patience.
Now, the other thing you have to be prepared for, with either of these two options, is to share your resources. For example, your partner may want to learn from you. "You are our shareholder, so help us."
MME: They are taking a 10 percent stake, what do they do to learn from you.
LIN: They can try to send people to you for training, for example, to learn how to do fundamental research, macro analysis, etc. Are you willing to devote your resources to that?
MME: Is there a company that's figured this out?
POOR: If you want a model that looks and smells a little bit like what you have experienced in the West, institutional is a great way to go. You have a better shot of finding two or three mandates and being able to raise $100 million or $200 million than you have of becoming a top three player in the mutual fund business in China.
Retail focused managers might consider if they even want to do business in China at all, and if they still do, they should recognize that it is going to be a five, ten, maybe even 15-year play.
But, conversely, you could look at a market like Taiwan, where the majority of the mutual fund assets are actually held in offshore funds.
LIN: If, for example, you want to sell your funds in Taiwan, you can do so through hiring a local master agent as an option.
And Taiwanese retail investors have a preference for offshore funds. They somehow think foreign asset managers are superior to the local ones.
BARRON: Asia is a huge market, but there aren't as many customers, on the institutional side.
MME: Who are the main customers?
BARRON: Well, you have the sovereign wealth funds.
CHEN: For the institutional segment, there's probably 30 to 50 names across all Asia.
BARON: As opposed to many thousands in the U.S.
CHEN: That you can address today. Now, that number is going to increase.
MME: How much money is at the behest of those 30 to 50 names?
CHEN: It's in the neighborhood of $1 to $2 trillion for sovereign wealth and pension funds. So it is not trivial. You know, if you look at China's State Administration of Foreign Exchange, it has $3.2 trillion. Not all of that is allocated to asset classes that foreign managers can address. But just a portion that foreign managers can address is several hundred billion. So they're bigger than CalPERS.
MME: Do you have any final thoughts on the challenges of doing business in Asia?
LIN: The other challenge you may face is the fee structure. Some institutional investors in Asia are now beginning to ask for performance-based fees, like the fees charged by a hedge fund. Charge a very low fixed fee, with then a percentage of performance-based fee. Some asset managers may not be willing to do that, because that can mess up their internal compensation system, or may generate conflicts of interest in some cases.
And, also, in terms of investment return, a lot of Asian investors, including some institutional investors, are now setting their eyes on absolute return through tactical market timing. They may ask you a question: "Well, the market is down. How come you are still 95 percent invested in the market? You should sell and then put the money into fixed income." Well, but that may not be your investment method.
But some Asian investors don't think like that. So how do you balance that?
BARRON: You have to do your homework about what the client needs. Understand their goals and objectives, and match your skill sets and capabilities.
LIN: And sometimes you have to be willing to walk out, to forego the opportunity, and you also need to learn to be humble.
CHEN: Yes. Learn to be humble.
LIN: Be patient. Be disciplined. And be flexible without compromising your principles. In other words, align what you do best with the needs of the local clients. That is the key for success.
CHEN: It is really more like a consultative approach. You have to understand all these pieces. Listen to the customer first, have a great understanding who they are, who you are, what's your strength, what you can offer that's better or best in that market. If you can marry those, you are going to win.
This information is for discussion purposes only, and should not be used for tax, legal or investment advice. The reader should consult with their independent tax, legal or investment advisor for guidance.
Any views expressed here are the views of the participants and do not necessarily reflect the views of Citigroup.