A tale of two worlds: China's markets

Author: | Published: 1 Jul 2005
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Given the pioneering nature of the fund management business in China's large but unruly domestic stock markets, it seems appropriate that the offices of Invesco Great Wall Fund Management Company (IGT) are in the frontier town of Shenzhen, just across the Shing Mun river from its salubrious neighbour, Hong Kong.

The offices of IGT, one of the early entrants to the market, certainly look the part. Aside from two huge toy bulls that guard the reception area, each sporting Invesco Great Wall rugby shirts, the remainder of the floor is given over to the trading desks and computer screens one expects to see in any serious fund management operation.

Amvescap, the parent company of Invesco Asia, is certainly taking its China joint venture with local securities firm Great Wall Securities seriously. Based in the US, Amvescap is one of the world's largest independent fund managers, with assets under management of more than $374 billion. IGT was established in June 2003 following the relaxation of restrictions on the ownership of domestic fund management companies by foreign investors. A joint venture with capital of Rmb100 million ($12.1 million) and a staff of 50 already, the equity is shared 33% each between Invesco and Great Wall Securities, with two additional domestic minority partners, Kailuan Group and Dalian Shide Group, holding 17% each.

The beauty of the deal, according to chief investment officer Patrick Shum, is that Invesco has management control despite the shareholding structure. "Great Wall allows us to have full management control of the company," he says. "It's a gentlemen's agreement. There is also an understanding that both Invesco and Great Wall will increase their stakes in the joint venture."

That, says Shum, will come at the expense of the existing minority holders and will result in Invesco and Great Wall each holding 49% of the company. "We've already submitted for approval of the increase," he says.

The move, once sanctioned by the Chinese authorities, will leave Invesco in one of the strongest positions of any foreign partner in a China fund management venture. "All the other joint venture companies have local parties with 51% or more," says Shum, "and in terms of a 49% shareholding, there's only one other firm ahead of us."

Under control

The point of all this jockeying for control is that Invesco is able to direct its business much more strictly, claims Shum, although he admits that there is always a fine line to be trod with the authorities, which appear to differentiate between management and voting control. "Management control is very important," he says. "It's also what the Chinese government wants: they want to transfer knowledge to the local market. But the government still sees the securities market as strategic: they don't want to lose control of it."

Of equal importance for Invesco, Shum claims, was the choice of joint venture partner. In Great Wall Securities, Invesco might not have found the largest Chinese securities firm, but at least it found one that was solvent. "The majority of securities companies and Itics [international trust and investment corporations] are on the verge of bankruptcy," he says. "The benefit of a good local partner is that it gives you a good profile, even if you might not get full control."

That profile has helped IGT to raise sufficient capital from what is mainly a retail market to provide assets under management of approximately $400 million spread across four funds: equities, balanced, bonds and domestic growth. It is a respectable sum, but by no means the largest amount raised by a foreign fund management venture (see box on following page). Shum clearly finds seeking capital from China's retail market frustrating.

"It's very competitive," he says. "And to get people invested is very tough. A lot of people who make the decision don't control the money. It's very easy to make the decision to choose us from a performance basis, but it seems there are a lot of non-performance-related issues. People are willing to give whatever they can to get business. We can't afford to do that: we'd tarnish the name of our partners."

What makes the fund raising that much more difficult is that IGT does not get direct access to retail customers. "The major clients are retail," says Shum, "but you can't sell to them direct: China's just too big. So the big four banks are so important to get access."

IGT has already established marketing agreements with two of the big four banks, Bank of China and Agricultural Bank of China, which also act as custodian and trustee banks, but the agreements are not exclusive and the banks also distribute investment products for IGT's competitors.

The joint venture line-up

Invesco is by no means the only international fund management firm to have signed up for a joint venture with domestic institutions in China (see the accompanying table). In fact, Invesco Great Wall Fund Management is not even the largest fund.

Several existing businesses boast assets under management of more than $1 billion, including joint ventures such as those between Dutch bank ING and China Merchant Securities, Dutch/Belgian asset manager Fortis Investments and Haitong Securities, and France's Société Générale and Fortune Trust & Investment.

There are currently 12 fully operational Sino-foreign fund management joint ventures. Recent market entrants include UBS, which opened its China joint venture with SDIC Hongtai Trust & Investment by taking a 49% stake in UBS SDIC Fund Management in April of this year, and Deutsche Bank, which signed a joint venture agreement a month earlier with one of China's largest domestic asset managers, Harvest Fund Management.

Several deals are also rumoured to be in the pipeline, including a joint venture between Schroders and Bank of Communications and CSFB, Industrial Commercial Bank of China and Cosco. Other deals are already signed, but are still awaiting the approval of China's Securities and Regulatory Commission, such as the Commonwealth Bank of Australia's tie-up through its First State Investments subsidiary with Hantong Securities, and HSBC Investments' agreement with Shanxi Trust & Investment Corp.

Despite the continued growth in the number of Sino-foreign fund management companies starting up new businesses in China, their total number is still only under a quarter of the total of such companies - combined market share is 21.8%, according to research firm China Knowledge.

Sino-foreign fund management joint ventures
Operational or signed
Joint venture Foreign partner Percentage ownership Principal Chinese partner AuM ($mn)
AIG Huatai Fund Management AIG Global Investors 33% Huatai Securities NA
BOC International Fund Management Merrill Lynch Investment Management 16.5% BOC International China NA
China International Fund Management JPMorgan Fleming Asset Management 33% Shanghai International Trust & Investment Company 202
China Merchants Fund Management ING 30% China Merchants Securities 1,408
DB Harvest Fund Management Deutsche Asset Management 20% Harvest Fund Management NA
Everbright Prumerica Fund Management Prumerica Financial 33% Everbright Securities 307
Fortis Haitong Investment Management Fortis Investments 33% Haitong Securities 1,809
Fortune SGAM Fund Management Société Générale 33% Fortune Trust & Investment 943
Franklin Templeton Sealand Fund Management Franklin Templeton 33% Sealand Securities NA
FSI Hantong Fund Management First State Investments 30% Hantong Securities NA
Fullgoal Fund Management BMO Financial Group 16.67% Fujian ITIC, Haitong Securities, Huatai Securities, Shandong ITIC, Shenyin Wanguo Securities 1,000
Guotai Jun'an Allianz Fund Management Allianz Group 33% Guotai Jun'an Securities 1,167
HSBC/Shanxi Trust HSBC Investments 33% Shanxi Trust & Investment Corp NA
Invesco Great Wall Fund Management Invesco 33% Great Wall Securities 427
SYWG BNP Paribas Fund Management BNP Paribas Asset Management 33% Shenyin Wanguo Securities 751
UBS SDIC UBS 49% SDIC Hongtai Trust & Investment 386
Xiangcai Hefeng Fund Management ABN Amro 33% Xiang Cai Securities 414
NA = Not available
Sources: Company reports, Euromoney research; KPMG; China Knowledge

Trading mentality

Holding onto retail money is just as difficult as raising it, largely because of the idiosyncrasies of China's retail investors. "All our funds are open-ended," says Shum, "so managing redemptions and subscriptions is our daily business. The problem is the different culture in China. In Hong Kong or other markets, when a client invests and you make money, they tend to feel happy about it and stick with the manager. Here, they'll feel happy but they often sell as well to lock in profits. They've got used to the trading mentality of the 'A' share market."

Equally perverse, says Shum, is the fact that losing money as a fund manager sometimes works in your favour when it comes to dealing with Chinese retail clients.

"Some funds have been very fortunate in raising huge sums," says Shum with evident envy, "even though they then lost money. People in China don't like to lose money so, if you do lose money for them, sure they'll shout at you, but they won't redeem. Apart from being shouted at, that's quite an enviable position to be in!"

If IGT's track record to date is any guide to the future, Patrick Shum and his colleagues might not be shouted at a great deal, but they are certainly likely to encounter more redemptions from retail investors locking in profits. Although the funds have been in existence for a relatively short time, they have all comfortably outperformed their benchmark indices (see table).

Compared with a market that overall slid 16% in 2004 and has already fallen another 10% in 2005, that is not a pedestrian performance. The secret, claims Shum, is that there is no secret.

"We have no tricks, no secret formula," Shum says. "It's very simple: it's about net profits and the quality and sustainability of earnings."

Invesco Great Wall Fund Management
China funds performance (as at March 31 2005)
NAV percentage growth
2005 ytd 2004 Since inception
Equity fund 5.90% 7.63% 21.67%
Benchmark -4.50% -13.09% -13.16%
Balanced fund 4.00% 6.85% 15.44%
Benchmark* 1.06% 4.04% 5.92%
Bond fund 1.12% 1.35% 3.01%
Benchmark 3.63% -3.32% 1.91%
Domestic growth fund 5.68% NA 8.00%
Benchmark -4.50% NA -13.82%
Net basis
* Twice bank deposit rate
Source: Invesco Great Wall

Stock picking

By that he means that IGT is adopting solely a stock-picking approach to investing in China's domestic stock markets. Starting with a universe of nearly 1,400 stocks listed on China's two stock markets, Shanghai and Shenzhen, IGT adopts a strict filtering approach, looking for three kinds of securities: growth stocks with sustainable revenues and earnings, value stocks that show cyclical characteristics, and income stocks that offer stable dividend growth and a consistent payout ratio. That produces a potential investment pool of some 300 securities, from which a monitoring list of 200 stocks is derived.

The final stock selections are made on the basis of detailed data mining, analysis and company visits. "Information availability is actually very efficient in China," says Shum. "Before we visit a company we can know a lot of things already. Of course the quality of information can be very different. When we visit companies, we want to clarify their margins, the source of growth. Plus we want to talk to the very top guy - the CEO - to know how he manages the business."

One of the chief pitfalls of many Chinese companies is that they diversify into business areas unrelated to a company's core activities, simply to make more profits. Shum and his colleagues would prefer to avoid companies that do this. "The concept of opportunity cost is missing in China," says Shum. "As long as they're making money, they're happy. If they see someone making $1,000 from something, they'll copy it, even though it means they'll make $500. We really need to educate them on return on equity and return on investment."

Nevertheless, Shum says that he does come across a few managers in China who grasp the concept, if not the terminology. "We want to talk to these people," he says. "They don't need to speak the [jargon]."

Once IGT finds these more enlightened managers, their companies are simply added to the portfolio, which currently comprises some 30 stocks. There is no trading of volatility unlike in many more sophisticated equity markets - in fact, quite the reverse. IGT deliberately looks for alpha, not beta stocks, and its portfolio demonstrates a beta of less than 0.9, providing a stable and consistent pattern of growth.

It is an old fashioned, traditional approach to investing and with it, Shum claims, IGT is helping to dispel what he calls the four myths about China's stock markets.

The first myth, he suggests, is that China's market is overvalued. "People say there's no value [in the China markets]," Shum says. "But when I construct my own spreadsheet of around 200 stocks, I find it's not true. People didn't notice, but 2004 was a very important year [for China's markets]. There are still a lot of speculative stocks, but in 2004 the broad market earnings per share was up 35% while the market fell 16%. At the end of 2004, when we calculated it, the market was trading on roughly 16 times earnings and in 2005 earnings are growing 13%, which means that the 2005 prospective price/earnings ratio is 14.5. The market has come down another 10% or so since, and price to book is 2.2 times. It's cheap: no-one notices it, but it's cheaper than Hong Kong."

Not just Hong Kong either: in fact, the China markets are rapidly realigning with global comparables.

The second myth about China's stock markets is that they are purely speculative and dominated by stock manipulators. That's not the case, says Shum, who points to a change in investor perspective, as well as a continued shakeout of traders as evidence that the markets are gradually institutionalizing.

"We [foreign fund managers] have started to look at companies by fundamentals," he says. "The continued fall in the markets has driven out some of the retail investors, and speculators have gone bust. So the importance of speculation in the markets is in fact reducing."

Room for growth

Because of the disastrous past performance of China's stock markets, the investing public continues to view them as hopeless cases that investors will avoid for years. That is myth number three, Shum argues. "I often joke that the 'A' share market that I'm investing in must be a different one to the one I'm hearing about," he says, laughing. "People continue to be very negative about the markets. It's a very different outlook to our portfolio. Maybe we're living in two worlds!"

To dispel the fourth myth, that there is too much supply and too little demand in the markets, Shum cites some key statistics. The market capitalization of China's two stock markets is equivalent to just 30% of China's current GDP. Compare that with the US ratio of 110% of GDP or Japan's 70% of GDP and there is clearly room for growth.

Some of that growth will inevitably come from burgeoning private savings, already $1.9 trillion, more than four times the total market capitalization, as well as from equity mutual funds, already some $30 billion and growing by between $3 billion and $6 billion every year, claims Shum.

In addition to the demand side of the equation continuing to grow, the perceived supply-side problem, that of the state-owned shares overhang that has depressed share prices for years, might be about to be solved. In May, the government announced proposals to start the gradual disposal of these shares, although it will take many years to achieve this.

The combination of these four misconceptions about China's equity markets has led to six-year lows and it all adds up to what Shum calls the "China opportunity". Behind that, he says, is the fact that "slowly, quietly, this speculative market is moving towards a more institutional and fundamentals-driven market".

IGT's own challenge is to capitalize on its early good start to seize the China opportunity. To do that, the firm will need to raise a lot more than the $400 million it already manages, as Shum admits. "Given the current situation, I have the capacity to invest $1 billion," he says. "And there are still enough companies to invest in. As stocks continue to come down, the investment universe will expand. That's good for me."

But IGT will only be able to take full advantage of this if it can raise more capital; and it will probably need to turn to the institutional market to do that.

Unfortunately, IGT failed to secure a mandate to manage the much sought after funds of the National China Social Security Fund.

"The bulk of institutional money will be coming from the NCSSF," says Shum. "Last year we were on the final list of eight, but they only chose four [firms]. We're not sure when the NCSSF will next allocate funds."

In the meantime, IGT is relying on other sources of institutional funds. "Invesco has applied for a $50 million QFII [qualified foreign institutional investor] allocation," says Shum. "We'll have a big say in the investment of that. We've already got approval to act as an investment adviser for QFII. It's going to help the institutionalization of the market. We're also beefing up our capital at the moment."

Shum adds: "We need Rmb100 million net capital to get a licence to bid for the Enterprise Annuity Fund: it's a bit like the MPF [Mandatory Pension Fund - Hong Kong's compulsory retirement plan], although it's not mandatory."

Despite the fund-raising challenges ahead, Shum claims that he will not be hurried in to growing his business. "We'd like to turn our strong [investment] result into profitability and larger funds under management," he says, "but I'm not in a rush. We don't need to rush: we want to do it right. We have the name and performance in the market. Now we'll start to talk to the institutions: we're trying to do some more direct sales."

Based on IGT's track record thus far, those institutions would be well advised to listen. IGT has proved that there is money to be made in China's volatile and unpredictable markets, and the firm is well positioned to benefit from their gradual deregulation. Its challenge now is to grow its funds under management more aggressively in the next few years.

If it fails to do this, it might fall victim to the fate of so many other pioneers that blaze a trail in new markets: finding that latecomers come in and make the real money.

This article first appeared in the June edition of Euromoney and Chris Leahy is the Asia Editor of Euromoney.