China’s ETF challenges
Development of the ETF market faces hurdles but has massive potential
China’s exchange traded fund (ETF) market has grown quickly since the launch of the first ETF in the mainland – the China SSE 50 ETF – in February 2005. The onshore ETF market has grown to 165 ETFs, with combined assets under management (AUM) of US$82 billion. China’s onshore ETF market has grown at staggering rate in the past 10 years, faster than the global ETF market expansion in the period.
Offshore, most Chinese ETFs are serviced in Hong Kong with some 107 ETFs with AUM of US$40 billion. This is about half of the onshore market. Globally, around 200 offshore ETFs offer exposure to China. In the past five years, Chinese ETF trading has expanded to the US, Canada, Europe, South America, Israel and South Africa. This is in addition to Asia, where Chinese ETFs offering access to China are available to investors in Australia, Japan, Malaysia, Singapore, South Korea, Taiwan and Thailand, apart from Hong Kong.
“It’s an incredible growth rate when you consider how the Chinese market has been liberalized over a decade or so,” says John Davies, managing director and global head of exchange traded products S&P Dow Jones Indices. Yet ETFs are a small proportion of China’s financial market. Onshore equity ETFs, for example, have a combined AUM of about US$35 billion. This is 1.1% of the US$3.1 trillion combined free-float market capitalization of the Shanghai and Shenzhen stock exchanges. In most developed markets, ETFs account for 10-12% of the market. “To say that the growth potential for China’s ETF market is tremendous may be an understatement,” says David Lai, partner, co-chief investment officer of Premia Partners.
Further development of China’s ETF market faces several hurdles, including restrictions on market access, limited product range and investor education. Restrictions on market access are being addressed via reforms being pushed by regulators, with the launch of Stock Connect in November 2014 and Bond Connect in July 2017. These are cross-border schemes allowing overseas investors to trade securities in the Chinese onshore markets. Previously overseas investors could only access onshore assets through restrictive schemes such as QFII, RQFII, and QDII. Also key is the inclusion in June 2018 of the 230 blue-chip China A-shares in the MSCI emerging market index, the main benchmark for emerging market stocks. Money that follows the benchmark will need to buy Chinese stocks to avoid deviation, paving the way for an estimated US$20-300 billion in investments going into Chinese mutual funds.
Following the success of the Connect schemes and the impending MSCI inclusion, regulators are working on a similar cross-border scheme for ETFs — the ETF Connect. Details have yet to be released, though Hong Kong-based ETF providers and fund managers are preparing for it. Implementation, potentially later in 2018, could spark further development of the ETF market and broaden the range of products.
Although Chinese domestic investors have become more sophisticated in recent years, when it comes to ETFs they still prefer money market and plain vanilla products. This is evident in the asset allocation of onshore ETF investors, mostly retail investors. As of April 2018, about 53% of onshore ETFs are invested in money market funds, 42% equities, 2.4% commodities, 1.6% fixed income and 1% mixed assets.
“Most of the money is in money market funds. That depends on market conditions and the yield curve. Domestic equities have not performed well so far this year but they still attracted substantial investments. For the fixed income ETFs, it is tough for money to flow into the fixed income side because of the yield curve,” says Lai.
Once ETF Connect is launched, onshore investors will have access to overseas ETF products that will allow them to invest in non-Chinese assets particularly in the Asia-Pacific region, the US, Europe, Japan and Australia. They will also have access to more sophisticated ETFs such as smart beta ETFs, active ETFs, plus leveraged and inverse ETFs. “This means they will have more investment choices other than A-share ETFs. For mainland Chinese money investing in offshore markets, Hong Kong is the first choice. They have more confidence in equities and fixed income ETFs in Hong Kong,” Lai says.
Overseas investors will gain access to the onshore ETF market via ETF Connect. This will allow overseas investors to capitalize on the growth of small and mid-cap companies, mid-tier technology companies and other high growth sectors that have been off limits. However, it remains to be seen whether ETF Connect will be a hybrid between the Stock Connect and the Mutual Recognition of Funds (MRF), another cross-border scheme that allows Hong Kong and mainland Chinese fund managers to sell selected funds in each other’s markets.
“For features similar to Stock Connect they will be looking at trading turnover on a daily basis, whether it is liquid enough, or the minimum transaction history. For things related to MRF, factors will be total fund size, AUM, and investment focus in terms of geography,” Lai says. In terms of products that will be included in the ETF Connect, it may make sense to exclude any China A-share ETFs for the southbound (to Hong Kong) link. “For investors coming from mainland China, they do not need to invest in any China A-share ETFs in Hong Kong. They can do it onshore. Likewise the southbound ETF Connect should not include any Shanghai or Shenzhen-listed ETFs. For southbound, mainland investors will be interested in exposure they cannot get in the domestic market such as Europe or Japan ETFs,” Lai says.
For overseas investors who will be using the Northbound (to China) link of the ETF Connect, the main consideration will be the lower fees charged by Chinese onshore ETFs. Fees on onshore A-share ETFs are 50bps, half the fees charged (100bps) by H-share ETFs listed in Hong Kong.
Investor education is similarly vital for further ETF development. ETF promoters need to confirm that investors fully understand the products. The rapid rise of smart beta ETFs — often sold on the basis of paper-based performance — makes it more important than ever to avoid disappointing investors, according to Global ETF Research 2017 by Ernest & Young. This is echoed by Davies of S&PDJI: “The best thing that we have seen is that there is always a need for education on how to use these products because people have to understand what the ETF structure is, how to use ETFs, and what sponsors they get. That responsibility lies with everyone in the ETF ecosystem whether it be index providers like ourselves, current issuers, the exchanges, and to a certain extent the regulators.”
The unique nature of China’s financial system makes it doubly important that focused investor education programmes are conducted for ETFs as part of the market’s ongoing expansion. Investors need to learn more about ETFs, particularly the more sophisticated products such as smart beta ETFs, active ETFs as well as leverage and inverse ETFs. “We’re all in this together, so the challenge is ensuring that end investors are educated. It is a key task that is ongoing and that education does not stop with the end investor,” Davis says.