Reform Needed in China’s Fund Business

Editor’s Note: Robert Pozen is a senior lecturer at Harvard Business School and a senior fellow at the Brookings Institution. This post is based on an article by Mr. Pozen that originally appeared in the Financial Times.

I recently returned from a trip to Beijing, where I launched the Mandarin translation of a book that I co-authored with Theresa Hamacher entitled The Fund Industry: How Your Money is Managed.

The book was translated because the Chinese fund industry is expanding rapidly; Chinese mutual funds were introduced in 2001 yet held over $340bn in assets by the end of 2011.

However, the future development of the Chinese fund industry faces a stiff headwind. In China, most retail investors buy mutual funds hoping to score a quick short-term gain, rather than to generate long-term returns. The high turnover is usually costly to investors and stunts the development of the fund industry.

The short-term mentality of Chinese investors is reinforced by the fund industry, which spews forth an incredible number of new funds each year. Though fewer than 1,000 mutual funds exist in China, the industry launched 136 new funds in 2010 alone.

This flood of new funds is partly caused by large up-front commissions on fund sales paid to distributors, who also receive smaller fees on an annual basis. To collect these up-front commissions, distributors hype the new funds and investors rush to buy. But these investors hold for a relatively short time – until the next wave of new funds.

As a result, there are very few large funds in China that attract assets through long-term performance. One helpful reform would be to reduce up-front commissions on fund sales and put more emphasis on annual trailer fees that are collected only as long as shareholders remain in the fund.

A second reform would be to expand the distribution channels for mutual funds. In the past, fund distribution has been dominated by the largest Chinese banks. They often treat funds as one of many standard products in a financial supermarket.

In 2012, Chinese regulators took an important step by allowing four independent firms to sell mutual funds. Hopefully, these independent firms will advise their clients about fund purchases in the context of broader financial planning. If these independent firms are paid annual advisory fees instead of up-front commissions, they will be more likely to recommend buying and holding the funds with the best records.

Third, Chinese policymakers can increase the time horizon for mutual fund investors by more actively promoting private retirement savings. Employer-based retirement savings plans can contribute significantly to mutual fund asset growth if they are tax-advantaged. But the Chinese government offers little tax subsidy to such plans, known as enterprise annuities, so the take-up is very low.

Since the national government has a relatively low level of debt, it can afford to subsidise retirement saving, for example, by allowing taxpayers to defer income tax on contributions to retirement plans. Such tax incentives would bolster the retirement income of Chinese workers, who currently rely on weak public programmes. And for asset managers, such incentives would create a shareholder base with a longer-term approach to investing.

Unfortunately, the short-term mindset of Chinese investors represents a broader problem: a lack of confidence in China’s capital markets, which have been plagued by insider trading allegations and accounting scandals. Since investors may doubt the veracity of financial statements and company disclosures, they tend to trade based on the latest fad or rumour.

China’s securities regulators have begun addressing the problems in the country’s financial markets.

For instance, regulators in Hong Kong – where many mainland companies are traded – have proposed subjecting investment banks to legal liability if the companies they underwrite make misleading statements in connection with their IPOs.

Asset managers can do their part to reassure investors by bolstering their own boards of directors. Currently, independent directors must comprise at least one third of the board of a Chinese asset management firm. This limited degree of independence is not enough to ensure that directors will act in investors’ best interests. As an initial step, securities regulators should require a majority of directors to be independent – under a tighter definition of “independence”.

In short, while the Chinese mutual fund industry has expanded rapidly, it needs to move from trading to investing. Reforms in the asset management industry, as outlined above, can help bring about this shift.

More generally, Chinese regulators should promote investor confidence by tightening disclosure for public companies and increasing the independence of fund boards.

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  1. By Chinese Mutual Funds Need Regulatory Reform | ValueWalk on Wednesday, June 20, 2012 at 8:45 pm

    […] in the world, could take over America as the world’s largest economy. However, according to Robert Pozen, Author of The Fund Industry, mutual funds are facing tough times due to weak regulations, which […]