Hedge funds meet with apathy in China
ELLEN SHENG, Contributing Writer
HONG KONG -- When Beijing announced that approved foreign hedge funds could start raising capital in mainland China, market watchers thought it marked an important step in opening up the financial sector and a great opportunity for Western firms to access untapped riches.
But the response from wealthy Chinese citizens has been lukewarm since the launch of the Qualified Domestic Limited Partnership program last September. Six authorized foreign fund managers -- Man Group, Citadel, Oaktree Capital, Och-Ziff Capital Management Group, Winton Capital and Canyon Partners -- can raise yuan from individual Chinese investors under the program. So far, only Citadel has confirmed that it managed to fill its $50 million quota.
Hedge funds seem to be encountering the same difficulty that foreign fund managers have been battling for years in mainland China: lack of interest.
"Chinese investors are not very familiar with investment products in general, and offshore products have been very slow to catch on in China," said Chris Powers, analyst at Z-Ben Advisors.
The new program allows wealthy individuals in mainland China to invest in overseas hedge funds for the first time, taking yuan out of the country for investments elsewhere. A second quota is expected to come sometime in the summer, but specifics have not been released.
Citadel did not give details about its fundraising activities in China beyond the fact that it had filled its quota. The other funds declined to comment. Industry experts say that there are a number of reasons why the hedge funds are struggling to gain traction in China.
Chinese investors generally have little appetite for overseas investments. "They can make a killing putting their capital in property or wealth management products in China, with 10-12% short-term returns," said Andrew Collier, managing director at Orient Capital Research.
It also does not help that hedge funds are not allowed to seek funds from Chinese institutional investors, which are the largest investors in alternative products globally. The six funds are only allowed to accept investments from individuals with a high net worth -- generally taken to mean more than $1 million in investable assets, although there is no official definition.
And unlike retail mutual funds, which are largely distributed by China's four biggest banks, hedge funds lack a widespread sales network, meaning they must court high net worth investors themselves.
When it comes to relationship with local investors, they face fierce competition from trust companies, which offer wealth management products. These regionally based players are a major force in China's so-called shadow banking industry. With their large Rolodexes of local investors, trusts are the key funding channel for domestic hedge funds, said Powers. Success in pairing up with trusts is vital to foreign hedge fund managers, but developing these relationships will take time.
The tax treatment of overseas hedge fund investments also causes confusion. Taxation of capital gains in China can be "all over the place" and "there's no norm," said Keith Robinson, partner at law firm Dechert. Chinese investors are generally exempt from paying capital gains made from yuan-denominated A shares and foreign currency-denominated B shares, while investment gains from mutual funds are subject to individual income tax. Funds in China are also typically obliged to withhold some gains for tax purposes. But the position for hedge funds and their investors is unclear.
For the six funds, the small quota size -- even when it is filled -- prevents them from collecting a significant amount in fees. Hedge funds typically charge fees equal to 2% of assets under management and 20% of profits. At the same time, China is a new market that requires a lot of time and money before foreign funds can gain a foothold.
Difficulty in raising assets from Asian investors is not unique to China. A recent study by Barclays Capital found that hedge funds regularly overestimate the fundraising potential in the region. Although there is much untapped potential for hedge funds in Asia, "the reality is that the timing of the realization of this opportunity in terms of real flows to hedge funds remains unclear," the report said.
But managers of all asset classes are tempted by the sheer size of this particular market. China's trust assets under management reached a record high of $1.73 trillion last year. Its mutual fund industry had $561.5 billion in assets under management as of the end of March, according to the Asset Management Association of China.
Opportunities and obstacles
The upside for foreign fund managers in general is that the property market is becoming less attractive and asset growth at trust companies is slowing. Some of that capital is expected to flow into alternative investment products.
In May, China's average home prices fell for the first time in two years, and demand is continuing to cool. Meanwhile, there are question marks over whether trust companies can continue delivering the high returns that investors are used to.
"We've talked to intermediaries such as banks and asset managers that created these products," said Daniel Celeghin, Hong Kong-based partner at investment management advisory Casey Quirk. "They are seeing lots of demand, but it's getting harder to package products that pay 8% to 9% but are not toxic. They're running out of tricks and local debt that they are comfortable putting clients into."
The risks of investing in trust companies are also higher, as Chinese regulators have allowed a few high-profile defaults by trust products to send a warning message to investors.
But there is also new competition for investors' money. Domestic Chinese hedge funds, which mostly follow long-only investing strategies, have seen assets under management growing steadily since a temporary downturn in 2011. According to Eurekahedge, assets under management has reached nearly $3 billion as of April. These funds, known as sunshine funds, have been unofficial for years, but Chinese regulators enacted a law last June that allows them to register and raise money directly from investors.
There are other new investment initiatives in the works, including a China-Hong Kong mutual-recognition platform that would allow Hong Kong-registered funds to be sold in China and vice versa and a "through train" pilot program linking the Shanghai and Hong Kong stock markets.
Market watchers say that despite early inertia, foreign fund managers will continue to enter the market.
Collier at Orient Capital Research said both Beijing and foreign asset managers want to see Chinese investment abroad grow significantly. "Funds see a huge pool of capital and are obviously eager to tap into that pool ... At the same time, regulators in Shanghai are trying to modernize their financial sector. They're trying to make the renminbi more influential globally," he said.