For U.S. mutual fund marketers, China is the Holy Grail. Given the country’s fast-growing economy and its large and rapidly aging population needing to save for retirement, China’s fund market has enormous potential for growth. ¶ Although the fund industry started in China only a decade ago, funds in that country already hold close to $350 billion in assets. And given the expanding size of China’s economy, its fund assets could easily grow to several trillion dollars over the next decade. ¶ But the Chinese market has been tough for U.S. firms to break into, because both regulation and local preferences tend to favor homegrown funds over U.S.-sponsored offerings. In general, China encapsulates the difficulties that investment managers must address when trying to export mutual funds — one of the United States’ most successful financial products — to other countries.
The first obstacle fund managers face when looking to enter the Chinese market is regulation. Because of Chinese restrictions, managers can’t just take a fund already being sold in the United States and offer it to Chinese consumers. That’s because China uses national treatment for investment funds, requiring that all funds register with regulators in the country and comply with local rules. Since it’s very tough for funds to be registered in two countries at the same time, funds registered in China are sold only in China.
To be fair, most countries — including the United States — have a national treatment regime. There’s simply not enough international agreement on taxation and requirements for investor protection to allow for its alternative, called mutual recognition, to be broadly implemented. In fact, mutual recognition has taken hold only within the European Union and in a few emerging-market countries that allow European mutual funds to be used in retirement plans.
In consequence, most mutual funds are sold solely within the borders of a single country. Fund managers who want to go global usually do so by registering multiple versions of the same fund, often referred to as clone funds, in each of the countries it wishes to enter.
To protect its own markets, China has gone further than national treatment and placed two additional limitations on foreign entrants. First, to encourage the development of a homegrown fund industry, it requires that all fund sponsors be majority-owned by Chinese companies.
Therefore, the only option open to U.S. firms is to acquire a 49 percent (or lower) stake in a joint venture with a Chinese company. Many fund managers haven’t been thrilled by the prospect of being a junior partner — and possibly losing control over products and services — and have decided to pass on China for now.
Others see value in working with a Chinese partner who can provide local knowledge and, even more important, connections to distributors. Today, 41 of the 73 mutual fund management companies registered in mainland China are joint ventures with foreign firms, a roster that includes four of the top 10 fund complexes in the United States.
Once the joint venture is formed, another regulatory restriction comes into play: the limitation on investment in foreign securities. Like other emerging economies, China has sought to control capital flows. It limits inflows through the Qualified Foreign Institutional Investor regime. Despite liberalizing proposals, the regime sets a cap on the value of Chinese securities that can be purchased by foreigners.
To control capital outflows, China utilizes the Qualified Domestic Institutional Investor, or QDII, regime. Only those Chinese fund managers registered as QDIIs may invest outside the country — and then only up to the limits established by the State Administration of Foreign Exchange, with the appropriate acronym of SAFE. SAFE has granted $76 billion in investment authority to 98 firms, including 32 fund management companies.
The QDII regime can feel particularly constraining to foreign fund-management companies. Many of them are hoping to build a presence in China based on their investment expertise in non-Chinese markets.
In addition to the regulatory hurdles, foreign fund managers must also face the challenge of Chinese investors’ focus on short-term trading. In China, most retail investors buy mutual funds hoping to score a quick gain rather than to generate long-term returns. The high turnover is usually costly to investors and stunts the industry’s development.
There are trading-oriented investors in the U.S. fund industry as well. But because funds are extensively used for retirement savings, many more U.S. fund investors have a longer-term approach. Over the past two decades, they have held their fund shares for more than three years on average, according to the research firm Dalbar.
Chinese investors’ short-term mentality means a radically different business model for the Chinese fund industry compared with its American counterpart. While U.S. investment managers carefully consider fund launches, the Chinese industry constantly creates new funds.
In 2010, there were fewer than 1,000 mutual funds in China — and 136 fund launches in that year alone.
In China, distributors have every incentive to hype new funds — and then encourage investors to sell them once the next wave of new funds comes along. (In the United States, by contrast, incentives have been increasingly tilted toward keeping assets in funds.)
The distribution structure of the Chinese market reinforces the culture of short-term trading. Fund sales have traditionally been dominated by the largest Chinese banks, which often treat funds as one of many standard products in a financial supermarket rather than as part of an integrated financial plan.
As a result of all this churning, very few large funds in China attract assets through long-term performance, which is the key driver of success in the U.S. fund industry. This puts U.S. fund managers at a disadvantage because the skill they’ve honed — building long-term performance through careful security selections and expense control — is much less valued in the Chinese market.
Fortunately for U.S. managers, longer-term investing is gaining adherents in China, most critically among regulators who have recognized that the country needs a base of steady investors.
In 2012, the Chinese equivalent of the Securities and Exchange Commission took an important step by allowing four independent firms to sell mutual funds. The hope is that these firms will advise their clients about fund buys in the context of broader financial planning and will structure compensation to encourage a buy-and-hold strategy.
At the same time, Chinese policymakers have established a vehicle for private retirement plans at work, called enterprise annuities, which resemble 401(k) plans in the United States. If the U.S. experience is any indication, participants in these private retirement plans will invest with a longer time horizon.
But the uptake on enterprise annuities has been low — which is not surprising given their minimal tax incentives. With its relatively low level of debt, the national government can afford to offer much larger tax benefits to Chinese workers who save through private retirement plans. These plans would provide an important supplement to the government pension system, which is financially weak and does not extend to many rural areas.
Unfortunately, the short-term mind-set of Chinese investors is indicative of a broader problem: an overall lack of confidence in China’s capital markets, which have been plagued by insider-trading allegations and accounting scandals. Because investors may doubt the veracity of financial statements and company disclosures, they tend to trade based on the latest fad or rumor.
China’s securities regulators have begun addressing the problems in the country’s financial markets. For instance, regulators in Hong Kong — where the stocks of many mainland Chinese companies are traded — have proposed creating legal liability for misleading statements to investors.
To help build confidence in China’s investment institutions, asset managers should bolster the independence of their own boards of directors. Currently, independent directors must comprise at least one third of the board of a Chinese asset management firm.
This limited degree of independence isn’t enough to ensure that directors will act in investors’ best interests. As an initial step, securities regulators should require a majority of directors to be independent — and under a tighter definition of “independence.”
Of course, the responsibility for opening up markets does not rest solely on China. The market for funds in the United States, which also relies on a national treatment regime, is quite closed to foreigners.
The United States could — and should — take the lead in negotiating mutual recognition agreements with other countries to create a truly borderless market for mutual funds. Agreements would be limited to those countries that have equally high standards for investor protection.
Mutual recognition would allow U.S. funds to be sold freely in other countries. But it would probably be opposed by some U.S. fund managers because mutual recognition would allow foreign fund managers to register their funds with the SEC and sell them to U.S. investors. So the impact on U.S. fund managers would be mixed; they would benefit from access to other markets, but they would face greater competition at home.
Fund investors, however, would be clear winners. More choice and broader competition — combined with strong and consistent regulatory protections — would lead to better service and reduced costs to fund investors around the world.
Pozen (@Pozen) is a senior lecturer at Harvard Business School and a senior fellow at the Brookings Institution. Hamacher (@NICSAPres) is president of Nicsa. Together they are co-authors of “The Fund Industry: How Your Money is Managed” (Wiley, 2011).