Alan Fong | APAC Product Segment Manager, Asset Servicing
As mainland China moves to relaxing controls over flows of capital across its borders, Hong Kong’s prime position as a fund management centre presents new opportunities for asset managers across the world. The city faces increasing competition for its HK$17.4trn (US$2.2trn)1 fund management business. But its position as a gateway to China, combined with its reliable physical and legal infrastructure, will continue to give it a crucial advantage.
Hong Kong has long been of paramount importance as an offshore RMB hub, with a pool of over RMB1trn in 2015.2 Now, as mainland regulators take steps to give international investors more direct access to Chinese assets and Chinese investors greater access to the outside world, Hong Kong’s importance in fund management is being magnified. Landmark schemes like Stock Connect, linking the Hong Kong equities market with that in Shanghai (and soon Shenzhen) and the Mutual Recognition of Funds (MRF) program that allows funds domiciled in Hong Kong to be distributed in the mainland, and vice versa, are potentially game-changing.
In light of these developments, international asset managers are re-evaluating their presence in Hong Kong and considering the best means to seize the opportunities that its evolution as a gateway to China’s capital markets present. Against this background, BNY Mellon is examining some of the fundamental issues shaping Hong Kong’s future as a fund management centre and what they mean for fund managers keen to tap growing capital flows to and from China. How will the industry develop and how can asset managers globally position themselves to capitalise?
Though the pace of adoption of exchange traded funds (ETFs) in Hong Kong has so far been moderate, impending changes to cross-border investment schemes, combined with a more accommodating regulatory environment, mean this asset class is set to take off.
Globally, ETF assets have exploded in recent years, growing at over 24% annually for the past decade to reach US$3.3trn.3 While the lion’s share of these funds are still in Western markets (with US$2.4trn in the US alone), Asian markets have also seen a steady growth of institutional and retail funds flow into ETFs.
Hong Kong already leads in Asia (excluding Japan) in terms of market size, with 124 ETFs totaling some US$37.8bn in assets - versus US$34.4bn in mainland China and US$23.2bn in South Korea, the next biggest regional markets.4 Globally these are modest numbers (the US and Europe each had over 1,500 ETFs by October 20155), but there are several reasons to suggest the market for such products in Hong Kong is set to expand dramatically.
The likely inclusion next year of ETF products in the Stock Connect schemes linking the Hong Kong exchange to those in Shanghai and Shenzhen is the biggest impetus. Regulators announced the move in August 2016 that ETFs would be included in both schemes after the Shenzhen link had been in operation for “a period of time” and “upon the satisfaction of relevant conditions”.
Though several practical questions about the move are yet to be answered, the inclusion of ETFs in Stock Connect could transform the Hong Kong market.
“This is the first opportunity that mainland investors will have to invest directly in foreign ETFs,” says Alan Fong, APAC Product Segment Manager at BNY Mellon. “This stands to be transformational for the Hong Kong market, making it considerably more diverse and international.”
Fund managers in Hong Kong providing ETFs based on international indexes are likely to be the biggest winners, as Chinese investors seek greater (and quotafree 6) exposure to overseas assets. Currently, the majority of Hong Kong ETFs are “vanilla” equity products, with mainland A-share based products accounting for around onethird of the average daily turnover,7 but the demand for exposure to more diversified assets will intensify.
Southbound flows will also be boosted by greater capital flows from mainland institutional investors. Significantly, in September this year the mainland insurance regulator announced that insurers could buy equities through Stock Connect, which could unlock a large amount of capital into Hong Kong listed stocks - including ETFs when they are allowed into the schemes.
While mainland demand for exposure to international assets is likely to lead to greater diversification, the stage is also set for the launch of a wider range of product structures. These include inverse and leveraged ETFs (which allow going against the market and are designed to multiply price changes in the underlying assets), as well as actively managed and “smart beta” products.
Hong Kong regulators have understandably been cautious in allowing new ETF structures, with concerns over investors’ understanding of the risks and the potential volatility caused by their daily unwinding of positions. South Korea, for example, already has 39 leveraged or inverse ETFs, worth 15.4% of the market,8 while Hong Kong is only starting to approve such products this year (excluding, for now, those focused on Hong Kong and mainland stocks).9
Still, as increasing variety of ETF products becomes more popular in other markets, the outlook for their adoption in Hong Kong is positive. “Active” ETFs10 have taken off in Europe in particular (thanks in part to the existence of an active UCITS share class), while new rules to rationalize the listing process for actively managed funds issued in the US in July this year will greatly speed up their approval.11
Active ETFs could be particularly popular among mainland investors. “Many don’t hold funds for long periods, preferring to trade in and out quickly,” Alan Fong says. “So having active ETFs in the Hong Kong market at lower cost than traditional managed funds could be very attractive to mainland investors.”
Another potential avenue for diversification is in “Smart beta” funds that are benchmarked against factors other than market capitalisation. These have proliferated worldwide, in part because they offer investors an appealing middle road between passive index-tracking funds and pricier active management. Their greater adoption in Hong Kong will to some extent depend on deepening investor education - which may also make regulators more relaxed about approving newer and more complex structures with a more informed investors base.
There is no doubt that an openness to innovative new fund structures and forms is equally as important to Hong Kong’s fund management industry as the city’s links to the mainland.
“To maintain competitiveness, Hong Kong fund managers and regulators need to consider more than just the city’s position as a conduit to and from mainland China,” says Steve Cook, Managing Director, Structured Product Services at BNY Mellon. “They must keep an eye on innovations and best practices among their peers, while also leveraging Hong Kong’s central role in the opening of China’s capital markets.”
The impending inclusion of ETFs in the Stock Connect programs and the adoption of more varieties of exchange-traded products mean the outlook in Hong Kong for exchange-traded products, and fund management in general, is increasingly bright.
Of course, asset managers in the city offering such products will have to contend with the realities of maintaining increasingly complex ETF portfolios, with new structures requiring much more advanced custody, fund accounting and administration services. As ETFs come to play a crucial role in the movement of capital across China’s borders, having these services available in Hong Kong, in real time, will be increasingly vital to maintaining competitiveness.
1 Source: Hong Kong Securities and Futures Commission’s Fund Management Activities Survey 2015 report, published July 2016
2 Source: Hong Kong Securities and Futures Commission’s Fund Management Activities Survey 2015 report, published July 2016
3 As of October 2016. Source: ETFGI
4 As of September 2016. Source: ETFGI
5 Source: ETFGI
6 Flows will still be subject to daily quotas in the Stock Connect schemes, although aggregate quotas for both schemes will be abolished. Source: Hong Kong Stock Exchange, presented by Charles Li, HKEX Chief Executive on 16 August 2016.
7 Source: Hong Kong Stock Exchange’s ETF and L&I Product Market Perspective report (August 2016)
8 Additionally, it has 5 ETFs leveraged inverse ETFs. As of September 2016. Source: ETFGI
9 Source: Financial Times’ article on 13 June 2016 titled “First leveraged ETFs launch in Hong Kong”
10 Actively managed ETF is ”an exchange-traded fund that has a manager or team making decisions on the underlying portfolio allocation or otherwise not following a passive investment strategy. An actively managed ETF will have a benchmark index, but managers may change sector allocations, market-time trades or deviate from the index as they see fit. This produces investment returns that will not perfectly mirror the underlying index.” Source: Investopedia
11 Source: Bloomberg article on 23 July 2016 titled “SEC Clears Rules For Speedier Approval of Actively Managed ETFs”
BNY Mellon is the corporate brand of The Bank of New York Mellon Corporation and may be used as a generic term to reference the corporation as a whole and/or its various subsidiaries generally. This material and any products and services may be issued or provided under various brand names in various countries by duly authorised and regulated subsidiaries, affiliates, and joint ventures of BNY Mellon, which may include any of the following. The Bank of New York Mellon, at 225 Liberty St, NY, NY 10286 USA, a banking corporation organised pursuant to the laws of the State of New York, and operating in England through its branch at One Canada Square, London E14 5AL, registered in England and Wales with numbers FC005522 and BR000818. The Bank of New York Mellon is supervised and regulated by the New York State Department of Financial Services and the US Federal Reserve and authorised by the Prudential Regulation Authority. The Bank of New York Mellon, London Branch is subject to regulation by the Financial Conduct Authority and limited regulation by the Prudential Regulation Authority. Details about the extent of our regulation by the Prudential Regulation Authority are available from us on request. The Bank of New York Mellon SA/NV, a Belgian public limited liability company, with company number 0806.743.159, whose registered office is at 46 Rue Montoyerstraat, B-1000 Brussels, authorised and regulated as a significant credit institution by the European Central Bank (ECB), under the prudential supervision of the National Bank of Belgium (NBB) and under the supervision of the Belgian Financial Services and Markets Authority (FSMA) for conduct of business rules, a subsidiary of The Bank of New York Mellon, and operating in England through its branch at 160 Queen Victoria Street, London EC4V 4LA, registered in England and Wales with numbers FC029379 and BR014361. The Bank of New York Mellon SA/NV (London Branch) is authorised by the ECB and subject to limited regulation by the Financial Conduct Authority and the Prudential Regulation Authority. Details about the extent of our regulation by the Financial Conduct Authority and Prudential Regulation Authority are available from us on request. The Bank of New York Mellon SA/NV, operating in Ireland through its branch at 4th Floor Hanover Building, Windmill Lane, Dublin 2, Ireland, trading as The Bank of New York Mellon SA/NV, Dublin Branch, which is authorized by the ECB and registered with the Companies Registration Office in Ireland No. 907126 & with VAT No. IE 9578054E. If this material is distributed in or from, the Dubai International Financial Centre (“DIFC”), it is communicated by The Bank of New York Mellon, DIFC Branch, which is regulated by the DFS and located at DIFC, The Exchange Building 5 North, Level 6, Room 601, P.O. Box 506723, Dubai, UAE, on behalf of The Bank of New York Mellon, a wholly-owned subsidiary of The Bank of New York Mellon Corporation. This material is intended for Professional Clients and Market Counterparties only and no other person should act upon it. BNY Mellon also includes The Bank of New York Mellon which has various subsidiaries, affiliates, branches and representative offices in the Asia-Pacific Region which are subject to regulation by the relevant local regulator in that jurisdiction. Details about the extent of our regulation and applicable regulators in the Asia- Pacific Region are available from us on request. Not all products and services are offered in all countries.
The material contained in this document, which may be considered advertising, is for general information and reference purposes only and is not intended to provide legal, tax, accounting, investment, financial or other professional advice on any matter, and is not to be used as such. The contents may not be comprehensive or up-to-date, and BNY Mellon will not be responsible for updating any information contained within this document. If distributed in the UK or EMEA, this document is a financial promotion. This document and the statements contained herein, are not an offer or solicitation to buy or sell any products (including financial products) or services or to participate in any particular strategy mentioned and should not be construed as such. This document is not intended for distribution to, or use by, any person or entity in any jurisdiction or country in which such distribution or use would be contrary to local law or regulation. Similarly, this document may not be distributed or used for the purpose of offers or solicitations in any jurisdiction or in any circumstances in which such offers or solicitations are unlawful or not authorised, or where there would be, by virtue of such distribution, new or additional registration requirements. Persons into whose possession this document comes are required to inform themselves about and to observe any restrictions that apply to the distribution of this document in their jurisdiction. The information contained in this document is for use by wholesale clients only and is not to be relied upon by retail clients. Trademarks, service marks and logos belong to their respective owners.
© 2016 The Bank of New York Mellon Corporation. All rights reserved.