The Asian mutual fund story
While fund penetration has increased across the board, ETFs are gaining traction
By Stewart Aldcroft*
By any basis of measurement, the growth of offshore mutual funds in Asia has been outstanding over the last 15 years or so. Statistics alone show that both the number of funds and the aggregate value of investment in them have increased massively since 1995. This article aims to provide some of the background behind this phenomenal growth, and also aims to give some pointers to what might happen in the future.
In 1995 the Asian mutual fund industry had not really extended much beyond Hong Kong, Taiwan and Singapore. While the Hong Kong and Taiwan markets had fully embraced use of offshore funds, Singapore, at the time, had restricted access only to locally incorporated products.
Fund distributors were mainly the financial advisers in these markets, along with a few private banks and US-owned broker/dealer securities companies. However, things were about to change. In Hong Kong, banks such as Citibank and Standard Chartered had already realised the need to offer a range of "third party" funds to their customer base, had set up investment services departments and were rapidly training front-line staff in the skills required to promote funds to their wealthier customers. They had developed analytical departments to select suitable funds and managers, acting as "gate-keepers". HSBC had not moved beyond selling own-label funds; however Hang Seng had begun to develop a third party fund distribution service. In Singapore, the local banks had already begun to realise that their own fund management companies were producing products their customers might want to buy, so they also set about the training of front-line staff to deliver sales on these.
Within five years, by 2000, all the major retail banks in Hong Kong and Singapore had got in on the act, and very shortly they came to dominate the distribution landscape for mutual funds. Volumes rose from a market share of less than 15% to more than 85%.
Meanwhile, in Taiwan, the securities companies there had set up mutual fund distribution teams, which were delivering big volume sales to the fund companies based in Hong Kong. Taiwan, which many observers have regarded as having "perfect demographics" for the mutual fund business, had easily the largest sales volume within the region, and with it had begun the phenomenon of "investor tours" to Hong Kong. Many retail investors would undertake two or three day trips, part of which was spent in the fund company offices, the other in the adjacent shopping malls. Billions of assets were raised as a result, boosting the Hong Kong economy at the same time.
How could this have happened? To understand, it is necessary to take a look back at the history of the development of mutual funds in Asia. In the mid-1980's, the Hong Kong Office of the Commissioner of Securities (the regulator at the time) issued guidelines allowing the approval of funds for public distribution in Hong Kong (this followed a number of public scandals where fraudulent activity occurred). Possibly under pressure from the leading companies of the time, and in the aftermath of the agreement between the UK and Chinese governments to handover rule of Hong Kong from July 1, 1997; funds that had a domicile overseas from Hong Kong were able to gain authorisation alongside those with Hong Kong domicile. The presumption being that in the event that following the "handover" the economy collapsed and rule of law broke down, money invested via funds into securities could not be sequestered by the Chinese government as it was not actually in Hong Kong.
At the same time in Europe, the European Union (EU) had realised a need to formalise a patchwork of fund regulations and thus by 1985 they had developed UCITS (Undertaking for Collective Investment in Transferable Securities) as a set of guidelines to enable funds to be established, and for member states of the EU to approve their distribution. Luxembourg rapidly realised that by providing a central location with minimal local taxes, it was possible to create cross-border funds of interest to investors. These funds, known as "Societe d’Investment a Capital Variable" or SICAV, were an instant success. SICAVs were created as "umbrella" funds, whereby instead of single stand-alone funds such as unit trusts, multiple sub-funds each investing into a different market were able to be established, all under a single vehicle (or umbrella). These SICAVs were able to gain authorisation in Hong Kong, and fairly soon distributors in both Hong Kong and Taiwan realised they met the investment needs of many of their prospective clients.
Thus the "offshore fund" boom commenced, although the irony was that as most "offshore funds" were located in Luxembourg, they were in fact "land-locked".
Singapore, observant of these developments to the north, was persuaded to change their restrictive approach to fund authorisation in 1997, as a result of which "feeder funds" feeding into SICAVs where management of assets was carried out in Singapore, initially, could be distributed. Shortly thereafter, this change was extended to enable a wider choice of funds, ultimately leading to a more general offering without the need to be a feeder fund.
Retail investors liked what they saw. They went to their banks for advice, and soon the whole bank fund distribution business mushroomed. Although many banks attempted to only sell proprietary funds, they soon realised that if they didn’t offer those of a number of fund houses, their customers would take their business to the competitor bank along the street. Thus, it soon became necessary for banks to set up "gate-keeper" departments, to provide analysis and advice on selection of funds, and adopt approval lists of funds and fund companies. This also enabled the bigger bank distributors to gain leverage over the fund houses selected, to negotiate improved "terms of business". Generally, this meant that a bank distributor demanded, and received the whole of the front-end load for funds sold (5% usually) and a significant proportion of the annual management fee (often 50bps to 75bps) from sales made and assets under management. Fund distribution thus became an extremely profitable business for the banks, leading them to create ever larger "wealth management" departments. It has been estimated that many retail-focused banks in Asia were able to achieve more than 10% of their revenues from wealth management by around 2005, from virtually zero ten years earlier.
Jumping ship
While private banks had entered the mutual fund distribution market much earlier than their retail cousins, for many this became a bit of a roller-coaster ride. Not wishing to compete head-on with the retail banks, many of the private banks moved into hedge fund distribution, making the assumption, often not always as accurate as would be desirable, that their high net worth individuals (HNWI) were better equipped to understand the complexities of hedge funds as opposed to retail customers. This also led them to use structured products, where they were able to create more "attractive" investments for HNWI through use of leverage and other derivatives linked to hedge funds. These more "exotic" investment vehicles became more and more exotic over time, and the stock markets kept rising. Of course, as we all know, markets can fall as well as rise, and when in 2008 Lehman Bros collapsed, this, in effect, pulled the rug out from under many investors aspirations for using mutual funds to accumulate their savings.
What has often perplexed fund management companies is why in Asia so few institutional investors have used funds to invest, despite their widespread use in Europe and North America. Essentially, the prime reason for this appears to have been a concern expressed by the trustees of many institutional and pension funds; that they don’t wish to co-mingle assets with volatile retail investors, particularly where there is a prospect that rapid inflow or outflow of assets could occur. Many were also bothered by the relatively high charge structures mutual funds incur. Ease of access, high investment returns and immediate encashment didn’t seem to be sufficiently attractive aspects of the mutual fund offering. This has also extended to the hedge fund arena, as few institutions in Asia have, to date, used hedge funds.
Looking ahead
After the major crises of the last couple of years, most investors are very wary of where to put their money and from whom to receive advice. With the collapse of Lehmans in 2008, went the confidence that there were some organisations strong enough to survive. A contagion effect occurred where securities markets all took a big hit, none escaped.
This has led to greater efficiency in most securities markets, with increased regulation to prevent (or at least attempt to) any more serious collapses. With increased efficiency also comes less opportunity to find exceptionally priced stocks. As the US and European markets have found in the last ten years, fewer traditional mutual fund managers can consistently outperform their benchmarks. This led the US to rapidly embrace the exchange traded fund (ETF) products on offer. From a low base, by 2010 this has become a multi-trillion dollar market. In the US it has been the retail investor that has led the charge, proportionately taking around 60%+ share. In Europe it has been the institutional investor that has more readily accepted ETFs as the market there has rapidly increased in the last three years. For Asia, the ETF market is still in its early stages, and much of its success might depend on where and how they are distributed. Given the trading mentality of most Asian investors, it could be the opportunity that many securities companies have been looking for to enable them to enter the "wealth management" market aggressively.
Hedge funds in Asia have had a pretty rough time. Ignored by institutional investors, most Asian hedge funds have had to rely on raising money in the US, Europe or Japan to grow. The regulators in Hong Kong and Singapore have provided regulations to enable hedge funds to be authorised and thus promoted to the wider (retail) investing public, but incorporated requirements that even the biggest and best have difficulty in complying with. This has not been without its difficulties. Hedge funds will need a sustained period of excess returns to provide the confidence necessary to encourage investors to use their products.
For mutual funds, quite clearly, the range and choice of funds now available covers just about every possibility. QDII regulation in China, whereby a number of domestic asset managers were allowed to set up funds locally that could invest internationally, have provided a fillip in the last couple of years. The performance of most QDII funds has been very disappointing and thus the demand for more of these has fallen rapidly.
As with all investment products, the demand is very often determined by the end-investor wanting to buy-in. Experience shows, despite the extent of investor education that has been carried out, that most investors, whether retail or institutional, tend to buy at or near the top, and sell when times are negative. At the time of this writing, the returns from most markets, after their initial recovery from the collapse in 2008, has tailed off. Observers look to a sustained period of high, positive, market performance before they expect to see sales volumes for all types of funds rising to or exceeding previous high points of the 2006-07 period.
* Stewart Aldcroft came to Hong Kong in 1985 and has seen the mutual fund industry grow from less than 25,000 mainly expatriate investors to the ubiquitous household savings and accumulation vehicle it is today with many millions of investors. He has been employed by Schroders, HSBC, Franklin Templeton, Standard Chartered, Investec, Horizon21 and Enhanced Investment Products during this time, and has been at the forefront of market developments, many of which have been described above.