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State Street Expertise

Doing Business in China: What

Asset Managers Need to Know

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Like everything else about China’s scale, the size of the asset management business opportunity now and in the future dwarfs all other markets, at a time when asset managers are struggling to find new avenues for growth. McKinsey estimates that AUM in China will grow at over 17 percent annually over the next five years. The Chinese mutual fund market alone has quadrupled since 2013 to $1.7 trillion in AUM and is expected to grow to $3.2 trillion in AUM by 2022. But those mutual funds hold only 8 percent of personal financial assets in China, not to mention the $4.5 trillion held within the shadow banking system.1 And with recent regulatory changes, foreign asset managers face

the potential for owning a larger share of this massive market. But doing business in China as a foreign asset manager poses distinctive challenges as significant as the opportunities. Perhaps more so than in any other region, local tenure, talent and tenacity are key drivers of success. State Street’s Market Entry Solutions group brings all three of those attributes to the advice they provide to asset managers looking to establish a foothold in China. Donna Milrod, Head of State Street’s Global Clients Division, spoke to Hong-Kong-based Karen Liu, Head of Market Entry Solutions, about what asset managers need to know about this future-critical market in order to be successful.

1 McKinsey report on AM growth in China

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Donna MilrodHead of State Street’s Global Clients Division

Karen LiuHead of Market Entry Solutions, Hong Kong

STATE STREET EXPERTISE

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Managers Need to Know

• Regulations Now Allow for Greater Control and Broader Market Penetration

• Make Your Investment Large Enough to Provide Staying Power

• Local Talent and Relationships Are Mission-Critical

• Ensure Your Operations Are Aligned with Local Security Requirements

Greater Ownership Potential

Donna Milrod: The Market Entry Solutions group has been advising State Street asset manager clients looking to establish a foothold in strategic markets for many years. China obviously requires deep, on-the-ground expertise. What are the biggest surprises for foreign managers when you engage with them about breaking into the Chinese market?

Karen Liu: In our conversations with clients, we often have to remind them that China has gone through significant transformation over the past three to four years, clearing out some of the barriers to entry and addressing some

of the complexities that global asset managers historically faced.

In particular, clients are surprised to discover that the recent changes will allow them to assume greater control of the business than was previously possible. In the past, joint ventures (JVs) were the primary route into China for foreign managers, though ownership control was actually quite limited as foreign entities were not allowed to hold majority stakes in JVs. Prior to 2015, for example, there were only a handful of avenues that allowed global managers to tap into onshore assets, and they were limited to discretionary mandates awarded from asset owners and official institutions or investing into a JV partnership. Some of the early JVs were also not true partnerships, and the foreign manager had little influence.

Now the regulatory environment has evolved to allow foreign managers to establish wholly foreign-owned enterprises (WFOEs) that can service Chinese institutional clients with private funds. Starting in 2020 foreign managers will be allowed to expand their business to include public funds and retail investors. Regulators have also fast-tracked the ability for foreign

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companies with JV partnerships to acquire a majority stake in a local fund management company and reach 100 percent full ownership by 2020 instead of 2021. Lastly, managers will soon be able to participate in the pension and wealth management business with a separate fund management company. These are tectonic shifts in the opportunities for foreign managers.

So now we see managers becoming more resolute around their plans to enter China or to expand their presence. Global asset managers who currently

do not have a market presence do not necessarily need to start by entering into a JV with a local firm. By setting up a WFOE or evaluating other access channels into China, managers will be able to reach investors by developing distribution relationships with third-party platforms (IFAs2), online fund markets, and traditional bank channels. There is a plethora of distribution options and service providers that require their own relationship management. As such, a JV is no longer a critical piece for a foreign manager’s foray into China.

2 Independent Financial Advisors.

Source: McKinsey & Company, State Street press search.

• In September 2019, China announced that quotas for foreign investment access into China (in the QFII/RQFII programs) have been removed

• In July 2019, China announced that full foreign ownership of financial companies will be allowed by 2020 (over year earlier than previously announced)

• China’s domestic banks asked to separate their wealth-management businesses and strengthen risk-management practices

Before 2012

Investments quota introduced

Improved market accessibility to HK investors

Enlarge fund share limits for HK and Macau investors

Enlarge share limits for all foreign investors

New WOFE private funds and JV buyout emerges rapidly

More accelerated opening-up polices

2014-2015 2016 2017 2018 2019

Figure 01: China’s Key Regulatory Announcements (2000-2019)

Foreign entry restrictions have recently been relaxed to enable a level playing field, creating a window of opportunity for foreign players

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Donna Milrod: What does it take to establish a WFOE in China?

Karen Liu: Clients are also surprised to learn that operating in China requires a much greater investment of capital and resources than what they may have anticipated. Because it can be difficult for a manager to break even in the first year, we have seen many foreign firms quadruple their investments over the course of just a few years. Managers need to be able to not only sustain, but also grow their business. In other words, global asset managers will need to add capital to expand their infrastructure and support additional hiring key to their strategy in the market. Attracting the right talent can help drive the development of innovative funds that can attract additional business and expand on distribution and business development networks. We recommend that foreign asset managers add a buffer to whatever estimates they already have.

Local Talent Arms Race

Donna Milrod: What are the biggest misconceptions global managers have about the Chinese market?

Karen Liu: Global asset managers tend to assume that a strong international brand name alone will be a selling point in China. To be clear, a recognizable brand name helps open doors, but it is not enough in an incredibly crowded and competitive market. Today, there are over 24,000 managers operating in China’s private funds market, and within this group there are plenty of star managers with abundant experience in investing onshore. They are local, they know their home country, and they have the proper relationships and history with their distributors to help scale their products. Within this context, global asset managers really need to show that they understand China’s investment landscape well enough to deliver consistent fund performance and hiring the best local talent is critical.

Critical, but not easy. With more global asset managers entering the market and an abbreviated timeline for building a public fund business from scratch, foreign managers are scrambling to attract experienced locals with an international perspective. The talent pool is limited, so global managers will

3 Qualified Domestic Limited Partnership.

“Global asset managers need to show that they understand China’s investment landscape well enough to deliver consistent fund performance, and hiring the best local talent is critical.”

Karen Liu, Head of Market Entry Solutions, Hong Kong

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need to ensure that incentives are compelling enough to attract new hires and retain them as the company grows. It is not uncommon to see seasoned fund professionals jump from firm to firm, as demand heats up. Given the high demand and limited supply for this specialized talent, salaries can be on par with packages paid to investment professionals in Singapore and Hong Kong.

Global asset managers also tend to assume that their existing technology and operating systems can be easily leveraged doing business in China. However, China actually has very strict cybersecurity laws that can restrict the cross-border transfer of information. Personal data, trading instructions, and fund pricing are all considered classified or important data that cannot be easily transferred back to global headquarters. Asset managers need to engage their legal teams to ensure that their technology and information systems are in compliance with local regulations and to make Chinese regulators aware of any transfer of information back to global headquarters that does need to occur.

It is also important that managers diversify their approaches: committing to just one strategy, such as a private fund business, QDLP,3 or cross-border Mutual Recognition of Funds (MRF), is risky. Since entering China requires significant due diligence up front: building distribution relationships, gathering legal counsel, establishing the right compliance and operational frameworks, managers can leverage the relationships and lessons learned from one business and apply those to additional approaches so they have multiple options if certain paths are closed to them in the future. The same applies to product strategy.

Donna Milrod: What are the competitive differentiators between local and foreign managers in the fund management space?

Karen Liu: Local managers in the private funds space still have an advantage of foreign manager entrants because of their longer tenure in the mainland funds industry. Existing local fund managers have strategies with longer track records compared to those of many of the foreign managers, who are just starting to launch new funds.

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4 Source: China Securities Investor Protection Fund, March 2019. http://www.sipf.com.cn/dcpj/dccg/2019/03/12395.shtml

Figure 02: Chinese Retail Investor Behavior

Distribution of financial products with the largest investment allocation by the surveyed retail investors

Distribution of financial products by surveyed retail investor experience

Note: Survey drew responses from a total of 172,000 participants---10,000 participants made up the fixed sample pool and 162,000 participants made up the random sample pool.

Fixed Sample (n=10,000)

Random Sample (n=162,000)

Random SampleFixed Sample

33.2% 27.4% 27.1% 3.9% 4.8% 3.6%

39.4% 24.3% 20.5% 9.7% 3.0% 3.0%

Securities & Futures

Mutual Funds &

Pooled Assets

P2P & Trust

OthersPrivate Funds

No Experience

Bank Wealth Management

Produces

Insurance

10082.2%

74.8%

44.7%

21.8%

4.9% 7.1% 5.5%8.5%

1.3% 10.6%3.7%

26.9%

10.0%

65.8%56.8%

25.7%

50

Stock

Pool Assets

Deposit

Insurance, P2P and Others

Bank Wealth Management

Mutual Funds

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Many of these private funds command a certain following with investors and have established relationships with distributors, private banks, and institutions. While foreign managers may have capital to attract some of this star talent, they will also have to be able to provide a quality team of investment researchers and analysts to support the portfolio managers. Building an investment team with a good grasp of Chinese market fundamentals as well as emerging industries and trends will require significant time and resources.

Broader and Deeper Business

Opportunities

Donna Milrod: How would you describe the evolution of the opportunities in China from a target market (institutional, private wealth, retail) and investment vehicle perspective?

Karen Liu: We see a great deal of opportunity both in terms of target market as well as investment vehicles.

In addition to the institutional segment, global asset managers face growing opportunities in the retail space, largely driven by demographic trends as well

as regulatory changes. In particular, China’s retail market is around $2 trillion now, with nearly 60 percent of that in money market funds. Chinese regulators also recognize there is just too much invested in money market funds right now, which creates an opening for asset managers, both domestic and global, to introduce new funds and strategies that can generate higher returns for China’s emerging middle class.

China also recently announced the deregulation of its shadow banking industry, which lacked transparency into how assets were invested. Now Chinese banks have to set up separate asset management businesses and clearly disclose what their underlying investments are. These banks have expansive market reach, which includes China’s institutional, private wealth, and retail investors, and are currently sitting on a huge pool of assets from those investors. However, they don’t necessarily have the asset management expertise to deliver more sophisticated investment solutions beyond cash, fixed income, and deposit-type strategies.

“The ETF market in China is a completely green field in terms of product variability and sophistication.”

Karen Liu, Head of Market Entry Solutions, Hong Kong

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Global asset managers with a background in equities, multi-asset strategies, and fund of funds are quite appealing to these banks; and we are already seeing early discussions around potential strategic partnerships.

Overall, global asset managers have an opportunity to capture significant asset flows, particularly as China’s investors become more educated about the range of available financial products—which still have room to grow. Indeed, a 2018 survey of 170,000 Chinese retail investors found that investment awareness is still elementary, with survey respondents indicating familiarity with direct securities investments, but limited knowledge and experience with bank wealth management products, insurance products (often wrapped with pension benefits), mutual funds, and private assets. With the advent of new regulatory support for the funds industry and increasing investor awareness, fund managers face tremendous new opportunities to reach investors across a broad range of financial product types and strategies.

Donna Milrod: Where is China in the development of an ETF market and what role do foreign managers play there?

Karen Liu: The ETF market in China is a completely green field in terms of product variability and sophistication. Today, there are only 140 ETFs in China, and most of them are money-market-based or tracking the CSI 300. Global managers in China’s ETF industry already have a JV stake in a local fund management company that allows them to participate in the public funds market.

Asset managers are waiting with bated breath for the ETF industry to reach an inflection point, because of the challenging distribution landscape. Much like the rest of the markets in Asia, China’s fund industry is mostly bank- and advisor-dominated. Low-fee products like ETFs carry less of a sales incentive with advisors, so the retail take-up has been slow so far. But we are beginning to see some institutional adoption of ETF products (especially among Chinese insurers) and expect that will cause the ETF market to mature faster in the future. The manager to crack that market first will have a huge advantage.

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China’s Pension System–

A Sleeping Giant

Donna Milrod: Where is China in the development of a retirement savings framework and how would you describe the opportunity for foreign asset managers to capture those assets? How do you see that opportunity evolving?

Karen Liu: The Chinese pension system has three pillars:

1. The national social security fund, which is a state-run defined benefit scheme, representing 70 percent of the pension assets in China right now;

2. The enterprise and occupational annuities program, which is an employer-backed pension program, and makes up 30 percent of China’s total pension assets; and

3. The commercial pension scheme, which is negligible in terms of assets right now but offers the greatest growth potential for foreign managers.

China’s social security fund is expected to run out by 2035, so the country is under immense pressure to make up for that gap. The commercial pension program will attempt to introduce a tax-incentivized plan similar to defined

contribution plans that place the onus on individuals, rather than companies, to build up retirement savings.

While it is still early days, we think that foreign managers can be innovation drivers here. Once they are allowed to manage pension assets, we think global asset managers will see significant asset flows. However, it is important to have first established a presence in China to be positioned for that sizable pension opportunity.

Secrets of Success

Donna Milrod: For the managers who have navigated the Chinese market well, what do you think was the source of their success?

Karen Liu: Being opportunistic early on has worked well for some global asset managers. The early movers into China who have stuck it out with their joint ventures have earned dividends from that investment, despite the early uncertainties of operating in China. Some managers have also strengthened their competitive position by educating regulators and other key industry stakeholders in global best practices on topics such as how to structure an ETF or design target-date funds.

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But the essential ingredients are demonstrating unwavering commitment, hiring the right talent, and communicating competitive differentiators. For example, many managers are interested in tapping into China’s retail market, which is expected to grow to $10 trillion by 2025. However, only a few global managers have shown the commitment to build out the required marketing, business development, compliance, and operations capabilities. Additionally, the public fund market is still out of reach for some global asset managers from a regulatory standpoint. But they can set up a private fund operation and convert that into a public fund company in a few years’ time.

Global asset managers can also expand their reach and raise AUM and their brand profile by partnering with China’s emerging fintech platforms. Finally, an effective online content strategy is critical to raising awareness and credibility in a country where 70 percent of the population is connected to the internet.

Donna Milrod: What about concerns around intellectual property protection or political fall-out from trade tensions with the U.S.? Are these areas foreign managers need to be concerned about?

Karen Liu: Intellectual property concerns haven’t deterred foreign asset managers from setting up in China. For WFOEs operating in China, a lot of the decision-making around investment research, trading, and operations needs to be in isolation from the global parent because of regulatory restrictions on information transfers. As a result, many foreign managers are essentially setting up a separate entity in China and building it out with China’s domestic talent and technology and using local data sources. It is very much a closed ecosystem.

As for trade tensions, we have seen limited impact to global managers operating in China so far. Ever since the tariffs were imposed in 2018, Chinese regulators have actually doubled down on their commitment to open the fund market further for international firms. Chinese regulators recognize the

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For more information on State Street’s Market Entry Solutions team, go to

http://www.statestreet.com/solutions/by-capability/ssgs/invest-service/market-entry-solutions.html

critical role that international firms play in advancing the development of their domestic industry. As such, regulators are opening up previously closed-off segments of the market, removing foreign ownership caps, and amending inbound investment schemes in an effort to make it easier for global managers to do business in China.

Donna Milrod: What is the most important advice you have for asset managers trying to enter or expand their presence in China and how can State Street help them on that journey?

Karen Liu: China is a fast-moving market, so managers have to keep a close watch. There are nuances

that are not immediately clear to newcomers, and regulations can change overnight. New market entrants and products are introduced every week.

That is why we launched the Market Entry Solutions team for China, so that we can help clients stay on top of these developments and share insights about these critical changes. We work with local subject matter experts from State Street and across the industry to curate news and information that will help our clients navigate the distinctive challenges and opportunities that the market presents. China is an exciting, but also complicated, market; and we’re here to help.

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