China reforms favour stock pickers over index trackers

By Nishant Kumar

HONG KONG (Reuters) - Contrary to trends in the West, actively managed stock funds in China are set to become more popular with foreign investors, as moves to open up Chinese markets should give stock pickers an edge over poor performing index trackers.

Looking for a way into the world's second biggest economy, but intimidated by capital controls and strict investment quotas, investors have been piling billions of dollars into index trackers like synthetic exchange traded funds (ETF) that use derivatives to bet on mainland shares.

As access becomes easier thanks to reforms, including higher investment quotas and initiatives taken between the Shanghai and Hong Kong bourses to ease investment on each other's exchanges, that is about to change.

"As Chinese onshore equity markets open up to foreign investors, index tracking funds or ETFs on onshore Chinese equities may lose some favour," said Jackie Choy, ETF strategist for fund tracker Morningstar Asia.

Globally, ETFs have grown to manage over $2 trillion as a majority of actively managed funds in the mature Western markets are failing to beat their benchmarks. Seven of every ten equity funds investing in the U.S. equities have lagged the total gains in the S&P 500 index over the last five years, Lipper data shows.

Emerging markets actively managed funds, however, can exploit market inefficiencies.

China, however, because of the constraints on foreign investment, is the only 'big four' emerging market, or BRIC, that has an index tracker as its biggest equity fund.

About $30 billion or 40 percent of the money managed by China offshore equity funds is invested in index trackers. By comparison, only about 17 percent of assets under management of offshore India equity funds goes into index trackers.

Yet, many investors lost money using China index trackers despite years of economic boom producing some of the world's fastest growing companies.

While the MSCI China Index has fallen 40 percent since its launch in 1992, China's nominal GDP has surged 19 times during the period, according to Datastream.

Though cheaper and easier to invest in, ETFs are missing out on returns that actively managed funds are able to generate through stock selection and avoiding companies destined to fail.

Moreover, an index tracker raises exposure to China's banking sector, which is otherwise being shunned by investors due to mounting debt problems. The financial sector in the MSCI China index, for example, has a 36.6 percent weighting.

"Stock picking in China is important," said Anthony Tse, chief executive of Hong Kong-based hedge fund Pangu Capital.

"There are more investment landmines and frauds (in China), which you don't see as much in developed markets," said Tse, whose hedge fund has gained 19 percent since its launch on March 1 last year. During the same period the MSCI China Index rose a measly 0.9 percent.

In a sign of the changing taste in favour of actively managed funds, China focused hedge funds, that charge 2 percent management fee and 20 percent performance fee, hit record assets of $11.3 billion in April this year, data from Eurekahedge showed.

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Reforms should give managed funds more room to make money, and attract investors, even if their fees are almost double those charged by index trackers, industry experts said.

China is raising investment quotas for foreigners and giving them more access to the mainland market through initiatives like the Shanghai-Hong Kong Stock Connect system, due to be introduced later this year, which will allow stock trading between the two cities.

Regulators in Hong Kong and China have also agreed mutual recognition of funds, in a move that will allow those funds to be sold in each others markets.

Even operating under restrictions, China offshore actively managed funds have returned 33 percent on an average in five years to end of April.

The biggest one, $5.2 billion First State China Growth Fund, has gained 108 percent, data from fund tracker Lipper shows.

By comparison, index tracking China offshore funds as a group have gained 21 percent, while the widely followed benchmark by foreign investors, MSCI China Index, has risen 26.6 percent during the period.

Index trackers by design are not expected to outperform benchmarks but should closely follow the returns from them.

Six in every ten China offshore active funds have bettered the MSCI China's gain over the last five years, Lipper data shows.

(Editing by Simon Cameron-Moore)