Investors in China’s capital markets
Abstract:
This chapter mainly introduces institutional investors in China’s capital markets, such as securities firms, mutual funds, insurance companies, pension funds, and Qualified foreign Institutional Investors (QFIIs). Their investing behaviors and strategies as well as profit patterns are analyzed. In particular, the illegal behaviors of institutional investors, such as the tunneling phenomenon of Chinese fund management companies, are analyzed, explaining why it is not realized that the purpose of developing fund companies is to stabilize China’s stock market. Meanwhile, the opening up of China’s capital market, such as the developments of QFIIs and Qualified Domestic Institutional Investors (QDIIs), and their performance are examined. The government policies managing those institutional investors are also reviewed and discussed.
Introduction
Institutional investors play an important role in capital markets. In China’s capital markets, institutional investors mainly include fund companies, securities companies, qualified foreign institutional investors (QFIIs), insurance companies, pension funds, investment trusts, banks, financial companies, and non-financial listed companies. They can be divided into three categories. The first category is fund management companies. They take large market shares of China’s capital market and seek relative returns. The second category includes pension funds, insurance companies, banks, QFIIs, and financial companies. They normally take a long-term investment strategy and look for absolute returns. The third category includes securities companies, investment trusts, and non-financial listed companies. They seek absolute returns but often with a short-term investment strategy.
Chinese funds
Introduction to the Chinese fund market
China’s capital markets are fund management companies, due to their large size, market value and significant influence on the markets. There are two kinds of funds, publicly offered funds (public funds) and privately offered funds (private funds) (Figure 5.1). The main difference between them is that they have different regulators. Public funds are approved and supervised by CSRC, and raise capital through public offering to the general public; while private funds are without any official approval and supervision, and are often in the name of trusts. Private funds are raised through private offering to a limited number of individual investors, and are like wealth management products. According to their transparency, private funds can be divided into two types: sunshine private funds and underground private funds (Figure 5.1). Public funds have always been strictly regulated, with restrictions in some aspects, such as operation and clauses. But private funds are in a grey area without supervision and enjoy more freedom and flexibility in all aspects.
It is widely known that China’s fund management industry has formally developed since 14 November 1997, when Provisional Measures for the Administration of Securities Investment Funds took effect. In fact, before that, there were some funds launched, which were approved by either local governments or PBOC. Those funds are called “old funds”. The earliest local fund was established in August 1991 by Zhuhai International Trust Investment Corporation. The fund totaled RMB 69.3 million Yuan and was named the Zhuxin Fund. The first close-end fund was approved by the PBOC on 3 November 1992. It was called Zibo Fund (Zibo is the name of a city located in Shandong Province). The management company was called Zibo Town & Township Investment Funds Corporation Limited. On 20 August 1993, the fund was traded in SSE. By the end of 1998, there were 78 old funds in 22 provinces. Their total assets were about RMB 9 billion Yuan. Among them, 22 funds were traded in SZSE and SSE. Others were traded in local exchanges. A big problem for the funds was that no fund custodian system had been established.
Before 1998, it was individual investors who dominated China’s capital markets. These markets were full of speculations with irregular trading, which resulted in high market volatility. Then CSRC tried to solve the problem by developing qualified institutional investors. It decided to promote development of the fund management industry. CSRC tried to use funds as stabilizers of the stock markets. Since the old funds performed poorly due to lack of experience, often involved some illegal trading, and, more importantly, did not have official approval, CSRC decided to clean up the “old funds” according to the Provisional Measures for the Administration of Securities Investment Funds. The work was finished in 2001. Then, it started to approve the establishment of public funds according to Provisional Measures for the Administration of Securities Investment Funds. All funds were required to be supervised and regulated by CSRC. Meanwhile, a fund custodian system was established. Those funds are now called New Funds. After that, China’s fund industry was officially started. Its history can be divided into two stages: the closed-end fund stage and the open-end fund stage.
The closed-end fund stage was from November 1997 to October 2002. During that period, 54 close-end funds were launched. In 1998, two famous fund companies, Guotai Asset Management Co., Ltd, which was established on 5 March, and China Southern Fund, which was established on 6 March, were licensed for operation. Each of them issued 2 billion shares of fund. One was called Jijin Jintai (CNSESH 500001); the other was called Jijin Kaiyuan (CNSESZ 184688). Their maturities were both 15 years. In 1998 and 1999, ten fund companies were officially established. Besides the above two, the other eight were China Asset Management Corporation Limited, Penghua Fund Management Corporation Limited, Fullgoal Fund Management Corporation Limited, Harvest Fund Management Corporation Limited, Bosera Asset Management Corporation Limited, HuaAn Fund Management Corporation Limited, Changsheng Fund Management Company Limited, and Dacheng Fund Management Corporation Limited. They are called the “Old Ten Fund Companies” and had great influence on the Chinese stock market. They were the first closed-end funds. Since then, China’s closed-end funds have grown fast. From the second half year of 2001, the fund entered difficult times; and fund trading became less active. So, it was becoming difficult to launch funds. After October 2002, few closed-end funds were launched.
In September 2001, HuaAn Fund Management Corporation Limited, which was established on 4 June 1998, launched the first open-end fund in China. It was called HuaAn Innovation Fund (Fund code: 04001); and 5 billion shares were issued in total. From then on, China’s fund industry entered the open-end fund stage. From 2001 to 2005 was an early stage. One hundred and sixty-four open-end funds were launched. The total fund assets reached RMB 386.9 billion Yuan. On 1 June 2004, The Law of the People’s Republic of China on Securities Investment Funds took effect, replacing the earlier Provisional Measures for the Administration of Securities Investment Funds. That represents significant progress in laying the legal foundations for China’s fund industry. After 2005, due to the non-tradable share reform of China’s stock market, the open-end fund industry entered a fast development stage. By the end of 2010, there had been 665 open-end funds with market value of about RMB 2.4 trillion Yuan (Figure 5.2).
Figure 5.2 The total assets of funds and open-end funds Source: Data from CSRC (www.csrc.gov.cn)
Meanwhile, new fund products were developed. In 2002, the first bond fund and the first index fund were launched. In 2003, the first money market bond, the first principal-guaranteed fund, and the first umbrella fund were launched. In 2004, the first listed open-end fund (LOF), the first convertible fund, and the first exchange traded fund (ETF) were launched one after another. In 2005, the first mid-term and short-term bond funds were launched. In 2006, the first QDII fund was launched. In addition, some joint venture fund management companies were established after 2004 (Figure 5.3). But, there is a restriction on foreign investors. It is called the “1+1” policy, meaning that a foreign investor is not allowed to become involved in more than two fund companies, and can only hold majority equity of, or control, one fund company.
Figure 5.3 The development of fund management companies and joint venture fund management companies Source: Data collected from various sources
In addition, there are 18 custodian banks servicing fund management companies. The Big Five banks, ICBC, CCB, ABC, BOC and BOCOM, are the main custodian banks and take about 90 percent of the total fund assets. They are also the main sellers and distributors of fund products. More than 50 percent of funds are sold through bank outlets. Fund companies also directly sell fund products by themselves, which accounts for about 30 percent of the fund sales. The remainder is mainly sold by third parties. CSRC approved 162 qualified institutions to sell funds, including 61 commercial banks, 94 securities companies, three securities investment consulting firms and four independent sales companies. China’s fund industry reached its peak in 2007, when the stock market stood at the highest point. The total assets of the industry were increased by 81.72 percent and 282.52 percent in 2006 and 2007 respectively. After that, the total fund market size declined from RMB 3.3 trillion Yuan in 2007 to RMB 2.03 trillion Yuan in 2011. This is mainly due to the poorly performing stock market.
Performance of funds
China’s fund performance has often been unsatisfactory. Since funds were launched 12 years ago, at least RMB 2.4 trillion Yuan have been invested, while a profit of only RMB 345.03 billion Yuan has been made, which means that, after fund management fees are deducted, the return is only 7.09 percent, giving an annual return of only 0.64 percent. If inflation is considered, the return would be negative, or much lower than the savings interest rate during the same period. In 2001, equity funds achieved a return of 24 percent loss. Fixed income funds lost about 3 percent. Private funds did not perform well either. For the 702 underground equity funds that operated for more than one year, the annual returns were negative, –17.89 percent, better than the public funds. It was noted that there were 187 underground equity funds and 56 private fixed income funds for liquidation.
The performance of China’s fund industry is closely related to China’s stock market. The poor performance of China’s stock market can explain the poor performance of the fund industry. However, lack of incentive mechanisms in fund management is another reason. Fund management fees are charged based on fund size rather than fund performance. No matter whether a fund performs well or poorly, the fund management company always charges the same management fee. So, the fund management company is only concerned with the size of the fund. For example, for common stock funds, the management fees normally charged are from 1.2 to 2 percent. From 2001 to 2011, investors placed RMB 6.3 trillion Yuan in equity funds in total, and paid RMB 164.5 billion Yuan in management fees. However, the total returns were only RMB 75.4 billion Yuan, giving an annual return of only about 1 to 2 percent, much lower than banking interest rates.
In 2011, 64 fund management companies lost RMB 500.4 billion Yuan in total, while management fees charged by those fund companies reached RMB 28.86 billion Yuan. Only 15.09 percent of funds outperformed their benchmarks. China E Fund, one of the largest fund management companies in China, managed 30 funds in 2011, of which 27 lost money. It lost RMB 34.6 billion Yuan in total, while charging management fees of RMB 1.5 billion Yuan. In 2010, it lost RMB 3.43 billion Yuan and charged management fees of RMB 1.64 billion. Another famous fund management company, Harvest Fund, managed 30 funds in 2011. It lost RMB 27.4 billion Yuan, while charging management fees of RMB 1.8 billion Yuan. About 30 percent of the fund management companies have not brought returns for their investors, while they enjoy charging considerable management fees. In 2010, 60 fund management companies made profits of RMB 5.08 billion Yuan in total. However, the fund management fees reached RMB 30.219 billion Yuan. It can be argued that management fees should be charged based on the fund performance.
The lack of an incentive mechanism is also embodied in fund managers’ salary system. In May 2012, Mr Wang Yawei, who was a fund manager of ChinaAMC and had been widely recognized as the best fund manager on the mainland, resigned his position. He achieved 2,800 percent returns on his investments during his 14 years as the fund manager. Further, the returns he made for the shareholders of ChinaAMC were more than 200 times. He expected to receive equities of ChinaAMC, but was rejected. It is common in China that funds often bring great returns for the shareholders of the fund management company, while the funds buyers often receive limited returns or even lose money. Because there is no incentive mechanism, some fund managers choose to resign and switch to private funds. In 2011, more than 20 fund management companies lost more than three fund managers, and eight fund management companies lost more than four. Resignation has become a popular phenomenon in China’s fund industry (Table 5.1). In 2001, there were at least 111 fund manager resignations, and a total of 350 position changes.
Table 5.1
Fund manager resignations each year from 2007 to 2011
| Year | Fund manager resignations |
| 2007 | 83 |
| 2008 | 86 |
| 2009 | 86 |
| 2010 | 109 |
| 2011 | 111 |
Source: CSRC
In 2011, there were 44 changes of senior management at fund management companies, including changes of general managers, vice general managers and chairmen of board directors. Sixteen fund management companies, which accounted for about one-fifth of the total, changed their general managers. Seven chairmen of board directors were changed. Most of those fund companies were large fund management companies. In China’s fund industry, only two general managers of fund management companies served in the position for more than ten years. One is Mr Zhao Xuejun at Harvest Fund Management Corporation and the other is Mr Gao Liangyu at China Southern Fund Management Corporation. Although there are several reasons to explain the frequent changes of fund managers, such as lack of incentive mechanisms and policy restrictions on the public funds, few of the changes actually result from poor performance of the funds. There is no significant relation between fund performance and fund management changes. Frequent changes of fund management definitely affect fund performance, and indicate that corporate governance of fund companies may have some systematic problems.
Fund behavior
The performance of a Chinese fund is closely related to its stock selection strategy. Studying the fund industry shows that a differentiation strategy in stock selection has been popular and widespread. It is called the unique stock strategy. This means that the performance of a fund often results from selecting a unique stock, which is the stock held by only one equity fund or several equity funds under the same fund management company. By the end of May 2012, there were 2412 stocks in the “A-share” market, among which 298 unique stocks were identified.
From 1 January to 30 May 2012, the price increase of unique stocks was about 20 percent on average, while, during the same period, the SSE Composite Index increased by only 10 percent and the SZSE Composite Index by about 16.9 percent. In particular, a unique stock called Zhejiang Dongri (600113: SSE), which was held only by Lord Abbett Select 30 Equity Fund or LASEL30 (Fund code: 570007) under the Lord Abbett China, surged from RMB 5.41 Yuan on 28 March 2012 to RMB 17.41 Yuan on 25 April 2012, an increase of 220 percent in a month. Fund performance is closely related to the unique stocks. It has been shown that ST and *ST stocks accounted for more than 10 percent of unique funds from 2009 to 2011. In 2011, this figure was as high as 20 percent (Figure 5.4). In 2012, due to stricter supervision, few ST and *ST stocks were selected as unique stocks. Then, most of the unique stocks were selected by a top-down approach and closely related to China’s economic policies and performance. Another fund behavior is the cooperation between different funds under the same fund management company. When several funds under the same fund management company hold a stock, they support each other. Particularly, when the stock is sold, the funds reduce their holdings except for one fund, which stays and shelters the others’ withdrawal. Funds are even prepared to bear a loss for the other brother funds.
Fund tunneling
Tunneling exists in China’s fund industry in different ways. At least five kinds of tunneling are found in the sector (Figure 5.5). The first one is the tunneling from a fund management company to its shareholder, a securities company. By frequent trading, the fund management company can contribute to the securities company a large number of trading commissions (T1 in Figure 5.5). Although CSRC asks that a fund management company’s commission for a securities company should not be more than 30 percent of its total commissions of all funds in the year, it is frequently more than 20 percent. Another kind of tunneling, which is popular and well known by the public, is rat trading (T2 in Figure 5.5).
In mainland China, fund managers are banned from all forms of stock trading. However, some managers may use insider information and other people’s accounts for stock trading for their own benefit, which is illegal. The first reported rat trading in the fund sector was in May 2007 by Mr Tang Jian, the former manager at China International Fund Management Corporation, which was a joint venture between Shanghai International Trust & Investment Co., Ltd. and JP Morgan Asset Management (UK) Limited and was established in May 2004. He was convicted of using his father’s identity card to open an account for rat trading, and made gains of about RMB 1.5 million Yuan. CSRC seized all his rat-trading gains and fined him half a million Yuan. He was also banned from the markets.
The third type of tunneling is between two funds of the same family (T3 in Figure 5.5). There are two forms. One is from a new fund to an old fund, making the old fund perform well. Under the same fund management company, there are many funds; some are old and some new. To brand a fund company or make a fund perform at the top in fund ranking, a new fund may intentionally bear some loss or costs by buying the stocks, which are also in the old fund’s investment portfolio. The other type of tunneling is from a fund without self-purchased products to a fund with self-purchased products. Since 8 June 2005, fund management companies have been allowed to buy their own fund products for their own investment. For its own interest and benefit, a fund company may only buy one or two of its own products, while it is permitted to buy products from other funds. Meanwhile, the fund company makes a fund whose products are not purchased by the fund company support another fund whose products are bought by the fund company to make the latter fund perform better.
The next form of tunneling is also within the same fund management company. It is between the public fund and the fund specially managed for Social Security Fund (SSF) (T4 in Figure 5.5). To build and maintain a good relationship with SSF, the fund company may intend to make the fund managed for SSF perform well by tunneling. Because SSF has huge capital and each fund management company wants to be selected by SSF to manage SSF’s capital, good performance of the fund with SSF’s capital is important for SSF to continue to ask the company to manage its capital.
There is tunneling between a public fund and a private fund, and from the public fund to the private fund (T5 in Figure 5.5). Many public fund managers have transferred to work at private funds. They know public fund operations and have some close connections with the public funds. Cooperation between public and private funds may exist. A public fund manager may intend to sacrifice the interests of the public fund to support a private fund to obtain his individual benefits.
Tunneling, particularly rat trading, has been well known in the fund industry. In most cases, individual investors’ interests are damaged. However, due to lack of experience in supervision, the incomplete legal system and difficulty in obtaining evidence, as well as some fund managers’ moral hazard, it is hard to reduce the tunneling. For the near future, tunneling may still exist as a serious problem in China’s fund sector.
Supervision and the fund industry
CSRC is the regulator of China’s fund industry. It undertakes two kinds of supervision. One is supervision based on regulations; the other is called guiding supervision, without regulation. Supervision based on regulations means that CSRC supervises and manages the fund industry according to related regulations and laws. For example, according to Provisional Measures for the Administration of Securities Investment Funds, replaced by The Law of the People’s Republic of China on Securities Investment Funds published in 2004, CSRC uses the fund approval system to manage fund issuance. According to the Measures for the Administration of Securities Investment Fund Management Companies, CSRC manages the fund industry.
CSRC intended to make the fund product approval process standardized, transparent, and professional, and established an expert review system. So, in 2000, the fund approval system was initiated. However, it took too much time to approve a fund. For example, in 2000, the average approval time for a fund was 122 days, which had caused criticism from the public. CSRC then started to gradually liberalize the fund approval system, and the approval procedures were simplified. In 2002, CSRC proposed simplifying the approval process and reducing control to initiate market reform in the fund industry. It issued the Notification on Relevant Issues Concerning the Examination and Approval of Securities Investment Fund. The average approval time for a fund was reduced to 77 days. In 2003, CSRC issued Administrative Measures of Expert Review System for Securities Investment Fund. The time was then reduced to 37 days. In 2005, CSRC further simplified the fund review procedures and issued Circular on Relevant Issues Concerning the Further Improvement of Procedure for the Application and Examination of Raising Securities Investment Funds. The approval time was further reduced to 27 days (Figure 5.6). Meanwhile, CSRC adjusts approval time according to market conditions. When capital markets, such as the stock market, are not performing well, particularly in a bear market, the approval time is often much longer than in a bull market.
Figure 5.6 The average approval days for funds from 2000 to 2006 Source : CSRC (www.csrc.gov.cn)
The guiding supervision without regulation means that CSRC suggests funds meet some requirements. For example, CSRC asks equity funds to keep minimum equity holdings of 60 percent and maximum equity holdings of 80 percent. There is a double 10 percent restriction: the amount of a stock held by a fund should be no more than 10 percent of the fund net assets, and the stock amount held by all funds of the same fund management company should be no more than 10 percent of that stock’s total shares.
In October 2000, a famous financial magazine, Caijing Magazine, disclosed some truths and problems of the fund industry in an article titled “Fund Scandal”, such as funds buying and selling their own holdings to artificially boost trading volumes to attract other investors, and making transactions between two funds of the same family at a prearranged price, time and quantity. The pre-arranged trading actually manipulated stock prices with the intention of increasing the net assets value of funds in order to impress investors. The article was a heavy blow to China’s fund industry. Later investigation undertaken by CSRC showed that eight of the ten fund management companies were involved in illegal trading and behavior. CSRC then adopted the strategy of aggressively developing institutional investors so that the structure of China’s capital markets could be changed and improved.
CSRC expected developing institutional investors, such as funds, to take responsibility for stabilizing the stock market. By the end of 2005, the market value of China’s tradable shares held by the funds was 20 percent of the total capitalization of the tradable shares. Because of the difficulty in identifying the crime of insider trading and collecting evidence, the number of insider trading cases that go to trial is much fewer than the actual number. From early 2008 to the end of 2011, CSRC gained clues to 426 cases of insider trading, but only initiated investigations on 153 cases. Due to the difficulties in applying the law, few insider trading cases went to trial. By the end of 2011, Chinese courts had only tried a total of 22 criminal cases involving insider trading and disclosure of secret data, including one in 2007, one in 2008, four in 2009, five in 2010, and 11 in 2011.
On 22 May 2012, the China Supreme Court and Supreme Procuratorate jointly issued the Interpretation on the Handling of Criminal Cases Involving Insider Trading and Disclosure of Secret Data. It was the nation’s first judicial interpretation on insider trading. The legal guidelines have been in effect since 1 June 2012. The interpretation refines the definition of insider trading in a number of laws and regulations such as Securities Law, Criminal Law, and the Regulations on the Administration of Futures Trading. It defines “serious cases” of insider trading as any securities transaction involving RMB 500,000 Yuan or more; futures trading margins of more than RMB 300,000 Yuan; profits or avoidance of losses of RMB 150,000 Yuan or more; and three or more instances of insider trading or disclosure of secret data. However, it does not define specific terms on the behavior of “rat trading,” nor does it establish necessary supporting mechanisms. Loose regulations and lenient punishment have contributed to tunneling such as rat trading, which is a chronic problem in China’s stock markets and the fund industry. In the case of Tang, the punishment was not serious. The Criminal Law was not applied to tunneling such as rat trading until 2009. Criminal Law, which took effect on 1 March 2012, sets sentences of 5 to 10 years for “serious” cases of rat trading. Fines range from twice to five times the gains from illegal activity.
Securities companies
Securities companies are the most important intermediaries in China’s capital markets. The first professional securities firm was Shenzhen Special Zone Securities Firm, which was established in September 1987. In 1988, the PBOC, the central bank, financed the establishment of 33 securities firms nationwide. MOF and its local branches also established several securities firms. They were the first securities firms in China, and their initial purpose was for Treasury bond trading. In September 1992, approved by PBOC, three nationwide securities companies were established, including Huaxia Securities based in Beijing, Guotai Securities based in Shanghai and the China Southern Securities based in Shenzhen. In October 1994, the first joint venture securities company, China International Capital Corporation Limited (CICC), was established. When China joined the World Trade Organization (WTO) in 2001, CSRC approved nine joint venture securities companies, such as BOC International (China) Limited. On 20 September 2000, the listed company Hongyuan Trust, which was listed on Shenzhen Stock Exchange on 2 February 1994, was renamed Hongyuan Securities, and became the first securities company to be listed on China’s stock exchange. On 6 January 2003, CITIC was the first securities company to be listed on China stock exchange by IPO. By the end of 2010, there were 106 securities companies, including 15 listed companies. Their total assets were RMB 1.9686 trillion Yuan and their net assets were RMB 567.4 billion Yuan. Their revenues for 2010 were RMB 192.7 billion Yuan and their net profits were RMB 78.4 billion Yuan. Nine of them were joint ventures with total assets of RMB 108.5 billion Yuan and net assets of RMB 36.5 billion Yuan. The performance of securities companies is closely related to stock markets in mainland China. From 2002 to 2005, the whole securities companies industry lost money.
There have been three important restructurings in China’s securities companies, which are called the “Three Revolutions” of China’s securities firms. The first restructuring was in 1994, named “The separation of banking and securities business”. The second restructuring was from August 2004 to August 2007, called the Comprehensive Restructuring Program. The third restructuring, called the “1+1” Principle, started in 2008 and will be finished by 2013. In the 1990s, many securities firms were established by banks. Since 1994, the State Council has asked for commercial banks to be separated from securities firms, and banks are not allowed to become involved in the securities business. That caused the first restructuring in the securities firm sector.
The authority always expects institutional investors, such as securities companies, to stabilize capital markets when the markets are in turbulence. Before 2004, securities companies were the most important forces in China’s stock markets. However, due to weak supervision and few regulations managing securities companies, speculations and illegal activities were widespread in them. Insider trading and misappropriation of clients’ capital were popular. Although CSRC imposed sanctions on eight securities firms with very high risk, including Xinhua Securities, Anshan Securities and Dalian Securities, from 2002 to 2003, the serious situation did not change. Then, from August 2004, CSRC launched a comprehensive restructuring program to restructure the whole sector. Stricter supervision was then undertaken, and some securities firms were liquidated and restructured. By October 2006, 31 securities firms had been punished for violating regulations and laws, including the famous Southern Securities. At least three achievements were made by CSRC:
Mandatory third party custody of clients’ assets was implemented.
The Chinese Securities Investors Protection Fund Corporation Limited was established with registered capital of US$ 771 million in August 2005.
Securities firms were categorized by their risk exposure, and different supervision policies and measures were taken accordingly. The existing 130 securities firms were categorized into four classes (Table 5.2).
Table 5.2
The categories of securities firms
| Category | Qualification | Policies |
| A | Innovative companies | Qualified for innovative business besides traditional business |
| B | Standard companies | Qualified for traditional business such as IPO pricing, asset management, and financing on interbank markets |
| C | With high business risk | Targets of comprehensive restructuring program |
| D | With highest risk of failure | Targets of comprehensive restructuring program |
Source: CSRC
In July 2007, the category system was developed into five classes and 11 sub-classes, based on securities firms’ risk management capacity and performance, which were A (AAA, AA, A), B (BBB, BB, B), C (CCC, CC, C), D and E. “A-Class” firms have the best performance and risk management, while “E-Class” firms have the highest risk and worst performance in risk management. In 2011, there were 96 securities firms and there were no firms in D or E class (Table 5.3). CSRC asks all securities firms to follow the “1+1” Principle. The Rules on Supervision over Securities Companies, which came into effect from 1 June 2008, requires that an investor can have no more than two securities firms, and can only control one firm and participate in the other; this “1+1” Principle caused the third restructuring of the securities firm field.
In mainland China, the business scope of securities companies consists of brokerage, investment banking and innovative businesses. Since the 1990s, many Chinese securities firms have undertaken Collective Investment Schemes (CIS), which are similar to funds. Brokerage is the traditional and most important business for securities companies, and contributes more than 50 percent of the total revenue. Investment banking is an important business of securities companies. In 2011, 77 securities companies involved investment banking business, such as stock IPO, seasoned equity offering, bond issuance and convertible bond issuance. The market shares of the top five companies were only 27 percent. These were PingAn Securities, CITIC Securities, Guosen Securities, China Securities and GF Securities. PingAn Securities took 6.68 percent market share, making it the largest (Figure 5.7). So, the concentration ratio was low and the market was fragmented. The innovative businesses mainly include direct investment, asset management and marginal trading. In September 2007, two securities companies, CITIC Securities and CICC, were approved for a trial of direct investment business. By the end of 2010, 31 securities companies had been approved for direct investment business. According to SAC, in 2012, 114 securities firms received total revenues of RMB 129.471 billion Yuan, 4.7 percent less than 2011. Their brokerage business and investment banking business were poorer than in 2011, while innovative business performed better. The top three securities firms ranked by profits were CITIC Securities, Haitong Securities, and Guotai Junan Securities. Their net profits for 2012 were RMB 4.307 billion Yuan, RMB 3.234 billion Yuan and RMB 2.562 billion Yuan respectively. CITIC Securities made RMB 1.79 billion Yuan from its underwriter business, the most among all securities firms. Fifteen of the 114 securities firms lost money, in total RMB 5.11 billion Yuan. Morgan Stanley Huaxin Securities, which is a joint venture between Morgan Stanley and Huaxin Securities, lost the most in 2012; it lost RMB 105 million Yuan, about one-fifth of the total loss of the 114 securities firms.
Figure 5.7 Investment banking business of securities firms in 2011 Source: data from CSRC (www.csrc.gov.cn)
Qualified Foreign Institutional Investors (QFIIs)
To promote competition in the fund industry, improve fund management and attract long-term capital investment in China, China decided to open its fund industry to foreign institutional investors. In July 2002, the Rules on the Establishment of Joint Venture Fund Management Companies was issued and took effect. On 24 August 2006 the “Measures for the Administrative of Investment in Domestic Securities by Qualified Foreign Institutional Investors” (also called “New QFII Rules”) was issued, and took effect from 1 September 2006. China allowed licensed foreign institutional investors to trade A-shares on the secondary market. Priority is given to QFII applicants that manage closed-end China funds, insurance funds, pension funds, and other professional funds. The qualifying criteria of the QFII applicants are that the asset under management should be at least US$ 5 billion in the most recent financial year (the original requirement was $10 billion) and that the applicant should have more than 5 years’ experience in the fund management business. Under the New Rules, each QFII is now allowed to hold multiple securities sub-accounts with the Clearing House that correspond to respective multiple RMB special accounts. But, a QFII is asked to file reports on the underlying investors for whom it maintains the nominee accounts and on the investment activities of such investors through such accounts. The authority is taking a gradual strategy in opening China’s capital markets, and using quota control for QFII. In 2002, when the QFII system was first launched, the total quota was only $4 billion. On 11 July 2005, it was increased to $10 billion in total. Pushed by the Sino-US Strategic Economic Dialogue, the QFII quota was increased to $30 billion in 2007 and to $80 billion in 2012 (Figure 5.8).
Figure 5.8 QFII quota in total in different years Source: CSRC (www.csrc.gov.cn)
The first QFII was approved on 23 May 2003. It was UBS AG that obtained the license. By 2011, there were 135 QFIIs (Figure 5.9). QFII have been in China for 10 years. Their profitability has outperformed domestic funds. According to CSRC, by the first quarter of 2012, QFII had invested RMB 121.3 billion Yuan in total and the accumulated return reached RMB 144.3 billion Yuan. The annual return for the past 10 years was 11.9 percent, much better than the annual return of 0.64 percent for the domestic funds. By 2007, 28 joint venture fund management companies had been established.
Figure 5.9 The number of QFIIs in China’s capital markets Note: 2012* means by the end of June 2012 Source: CSRC (www.csrc.gov.cn)
Qualified Domestic Institutional Investors (QDIIs)
Investor (QDII) program, which was started in 2006, allows licensed domestic institutional investors to invest in overseas markets, provides Chinese investors with opportunities to invest in international capital markets, and helps China’s capital markets to balance the supply and demand of China’s foreign exchange market. China’s first QDII fund, managed by HuaAn Fund Management Corporation Limited, was launched in November 2006. The fund claimed to invest in stocks, bonds, real estate investment trusts and other mainstream financial products in international markets, such as New York, London, Tokyo and Hong Kong. The QDII product was so popular that on the first day of subscription it raised more than US$ 6 million. From 13 September to 20 October 2006 the subscriptions reached US$ 197 million from 16,652 subscribers. However, the QDII product had to bear a huge loss due to the bankruptcy of Lehman Brothers, since the QDII product was related to its products. Five years later, in 2011, the QDII fund was liquidated, and the fund buyers were paid back the principal at the original price of $1 per share. The buyers in fact lost 18.82 percent due to the devaluation of the US dollar.
QDII products were once popular. There were 18 and 24 QDII funds launched in 2010 and 2011, respectively. Most QDIIs make Hong Kong their investment priority. However, of 57 QDII funds in operation, only four have achieved a positive return. The best-performing fund achieved about 30 percent return since launch. The worst performance was more than a 50 percent loss. For example, Harvest Overseas Fund, which is one of the earliest QDIIs and managed by the largest fund company in China, Harvest Fund Management Corporation, has lost about 50 percent value since it was launched in 2007.
This poor performance has disappointed Chinese investors and given QDII a negative reputation. In 2011, no QDIIs achieved a positive return. In 2007, when the four QDII products were launched, investors had high expectations and there was a long queue to buy. The average initial fundraising for each QDII was over RMB 30 billion Yuan, much more than the average RMB 785 million Yuan for a QDII fund in 2011. Several reasons may explain the poor performance. One is the appreciation of the Chinese currency for the past 5 years. Another reason, which is important, is that Chinese QDIIs lack talented professionals who understand international capital markets and have enough investment experience in the markets. The fund managers of QDII are quite young, and 24 of them have investment experience of less than 1 year. It is surprising to learn that 11 of them have less than 100 days’ investing experience. One fund manager even has only 5 days’ investment experience. Another reason may be the restrictions on QDII investment. For example, CSRC requires that a QDII is not allowed to invest in derivatives; investment in stocks should not be more than 50 percent of the net asset value of its fund; and investment in a single stock should not be over 5 percent of the net asset value. In addition, some fund management companies, which may not be able to operate QDII products in international capital markets, launch QDII products only to make their product lines complete rather than really operating the products.
Insurance companies
Chinese insurance companies were not allowed to invest in the capital markets until 25 October 2004. After that, the insurance companies needed to obtain approval from China Insurance Regulatory Commission for their investments in China’s capital markets. But there are some restrictions on the investments. For example, seven kinds of stock, including ST stocks and stocks whose prices surged over 100 percent within the past 12 months, are not permitted. Investment in a stock should be no more than 30 percent of its total tradable shares. The investment ceiling is no more than 20 percent of insurance companies’ asset value of the latest quarter. In China, insurance companies have huge capital potential for investment; their total asset value is more than RMB 4 trillion Yuan. Insurance companies can have a significant influence on the capital markets. Their investment in the stock market was RMB 12 billion Yuan in 2005. One year later, it was RMB 77 billion Yuan. At the end of 2011, it reached about RMB 800 billion Yuan.
Pension funds
The most important pension funds in China are National Social Security Fund (NSSF) and provincial pension funds. China’s fast-expanding and powerful national pension fund, NSSF, has become a key investor in the fund and an indicator of the stock market; when NSSF starts to enter the stock market, this often indicates that the stock market is approaching the bottom and is going to turn around soon. Many investors may follow NSSF to enter the market. The NSSF was established on 1 August 2000 by approval of the State Council. The National Council for Social Security Fund (NCSSF) is in charge of managing the operation of the NSSF’s assets. NSSF aims to be a solution to the problem of aging and serves as a strategic reserve fund accumulated by the central government to support future social security expenditures and other social security needs. The funding sources of NSSF are as follows: fiscal allocation of the central government; allocation from the lottery public welfare fund; capital derived from reduction or transfer of state-owned shares; capital raised in other ways with approval of the State Council; investment proceeds and equity assets. By the end of 2011 the total assets under management of the NCSSF reached RMB 868.84 billion Yuan. The total was expected to be over RMB 1 trillion Yuan by the end of 2012. Due to its huge size, its investment can be considerable. But it has to take a passive investment strategy because safety is the most important thing for the fund. For example, at the end of 2009, the total assets under management of the SSF amounted to RMB 776.5 billion. Among different asset categories, fixed income assets accounted for 40.67 percent, domestic stocks 25.91 percent, equity assets 20.54 percent, global stocks 6.54 percent, and cash equivalents 6.34 percent.
SSF’s investment often forecasts the trend of China’s stock market. In October 2008, the stock market reached as low as 1664.93 points. In the next 3 months, from November 2008 to January 2009, SSF opened 32 new A-share accounts. After that, China’s stock market reached the high point of 3478 in August 2009. History shows that each time SSF starts to open new A-share accounts it is very likely that China’s stock market is approaching a turnaround point to go up. SSF also invests in PE. In 2011, it invested RMB 19.5 billion Yuan in 13 PEs; and the total investment in PE was expected to be RMB 30 billion Yuan by the end of 2012. Its annual return for the past 19 years is 9.17 percent. For the past 9 years, it has achieved an annual return of 18 percent from its investments in China’s stock market. Its investment in the stock market is only about 20 percent of its assets, while it contributes 40 percent of the total return. So, the stock market is important for its investments.
China’s local Social Security Fund amounted to about RMB 2 trillion Yuan by the end of 2011. Local pension funds are only allowed to invest in China T-Bills, while the national pension fund NSSF has more investment opportunities. The annual returns of local pension funds have been less than 2 percent for the past 10 years, and would be negative if inflation were taken into consideration. So, China may allow its local pension funds to be invested in its stock market in the near future to improve investment returns. Guangdong Province, a province in Southern China, has approval to transfer RMB 100 billion Yuan, or $15.84 billion, of local pension funds to the NCSSF for investment operations. The capital will be mainly invested in fixed-income assets, and some may be in the stock market. According to Mr Dai Xianglong, the Chairman of the NCSSF, allowing pension funds to enter the stock market does not mean that all funds will be invested in the market, and such investment may be first piloted in some developed provinces.
China enterprise annuity fund
China enterprise annuities are a form of supplementary pension plan that is supported by the Chinese government. Enterprise annuities were brought about through legislation that came into effect in May 2004. In order to offer enterprise annuities to employees, Chinese employers are required to contribute to and maintain the mandatory basic pension plans. Enterprise annuities are analogous to defined contribution plans, which are somewhat like American 401 K.
China’s enterprise annuity fund market is not large and so is attractive. By the end of 2011, Chinese corporate annuity funds amounted to a cumulative RMB 357 billion Yuan, accounting for less than 1 percent of the country’s GDP, far less than that in Western countries such as the United States and Canada. There are 21 institutes qualified for corporate annuity fund investment management, including 12 mutual fund companies, six insurance firms, two securities companies and one asset management institute. Of the 21 corporate annuity fund investment management institutes, only three had corporate annuities exceeding 20 billion Yuan. Due to fierce competition, some institutes have launched a “free of charge” offer for managing corporate annuity funds. According to regulations, investment managers are not allowed to charge more than 1.2 percent of the net value of a corporate annuity fund. While low fees have eaten into corporate annuity fund managers’ profits, they are under heavy pressure from clients, who remind them that they should not make losses. The cost of managing corporate annuity funds is high. An equity fund manager usually manages an amount between RMB 10 and 20 billion Yuan, while a corporate annuity fund manager usually handles 30 to 40 accounts worth about RMB 800 to 900 million Yuan. The primary difficulty facing those institutes was fierce competition in the small corporate annuity market. Many see these plans as a potential growth market. There may be ample room for development in the market in future.
Summary
China’s capital markets are full of individual investors. But it is institutional investors who dominate the markets. Fund companies, securities companies, and QFIIs are the most important players. Fund companies are closely related to securities companies. The authority expected funds to stabilize stock markets, while funds do not make this job their priority. QFIIs are small in their investment value compared with securities companies and public funds. But they have significant influence on the markets. Meanwhile, CSRC’s supervision seems not to be so effective. From 1 June 2013, when the Revised Fund Law (New Fund Law) comes into effect, China’s fund industry will see new investors joining in, such as PEs, insurance companies, securities firms, and private funds. Fund tunneling phenomena are widespread in the industry. Creating policies to manage the opening up of the markets, and developing models for supervising the players, are becoming more important for the future of the markets. Source: Data from CSRC (www.csrc.gov.cn)