Concerns over structured funds amid A-share swings

Concerns have been raised about investor education and product innovation in China’s structured funds market following wild swings in A-share prices over the past month.

The leveraged nature of the popular funds has meant that while investors enjoy big profits when shares rise, a bearish market can mean they suffer huge losses.

It comes after the Shenzhen Stock Exchange warned about the risks of nine funds on Tuesday, after China A shares posted their biggest single-day loss the previous day.

Structured funds are unique to China, and became one of the biggest-selling products during the IPO fund boom in the first half of this year. In total, Chinese fund managers had 168 structured funds at the end of June, while 55 of these were equity-type products launched in the first half.

These funds owned a total of Rmb517 billion ($83 billion) at the end of June, an increase of 165% from Rmb195 billion at the end of 2014, according to data compiled by Beijing-based Jian Financial Information and published by the Asset Management Association of China (Amac) on Monday.

Mid- to small-sized fund companies have been key players in structured funds. Shanghai-based Fullgoal Fund, Shenzhen-based Penghua Fund, and Shanghai-based SWS MU Fund (a joint venture between Shenyin Wanguo Securities and Mitsubishi UFJ Trust and Banking) are the top three companies for these products in terms of AUM, with 29.5%, 14.5% and 13.8% market share respectively as of the end of June.

A structured fund is usually an index fund which splits into two units, where unit A invests in low-risk securities and provides a low-yield return, and unit B borrows and leverages unit-B capital to capture a higher return. Both units list on an exchange for trading, and they usually carry two times leverage.

These funds are one of China’s seven leverage channels, representing 12.6% of the total market leveraging, Bank of America Merrill Lynch noted in a research note this week. 

Retail investors call the funds “money-making machines” due to the nature of the leveraging. But in a time of deleveraging and an equity market plunge, these funds have suffered the most in the industry. A total of 50 structured funds’ unit Bs lost more than 30% of their net asset value in a one-month period as of July 24, while the CSI300 index dropped 14.4% over the same period, according to Morningstar data.

In a lot of structured funds, when the net asset value drops about 75% a mechanism is triggered to maintain the leverage ratio between the A and B units of a fund. The Shenzhen bourse warned of the risk on Tuesday (July 28). 

Wang Qunhang, director of the fund assessment centre at Jian, said many retail investors buy into the funds after prices rocket, but they lacked sufficient knowledge of the risks. The whole industry has insufficient investor education, Wang said. One key reason for this is that most fund companies are busy tapping money during a bull market, and banks - the largest distributors - are not willing to provide education, Wang noted.

Wang urged the industry to provide more education to investors who are mostly equity investors with an appetite for risk-taking, and to build a risk warning system for such investors. Chinese regulators also need to set a higher hurdle for the listing of such funds, he added.

However, Wang pointed out the advantages of structured funds - for instance, they are vehicles which allow investors to execute trading strategies, and they ride the banking distribution channels but rely on brokers’ sales channels. 

Felix Ng, Singapore-based associate director of financial research firm Cerulli Associates, has worried that such leveraged funds could suffer when the market falls amid short-term volatility. 

Despite Beijing’s attempt at stabilising the market, analysts are not optimistic about efforts to push up the index. Lu Wenjie, a strategist at UBS China equity research, said China A shares’ downside risk was not likely to subside even after government intervention.

Lu noted that of those investors who suffered losses during the correction, many of them were still using leverage to catch the market rebound; but he warned that the mainland equity market has not become safe.

A-share volatility has been a headache for Chinese regulators in recent weeks. The CSI300 index fell by 31.9% from its closing peak of 5,371 points on June 10 to hit 3,659 on July 8. After enjoying a rebound over the following weeks, it plunged by 8.5% on Monday July 27, which was its largest one-day decline since 2007. Yesterday the benchmark closed down 2.93% at 3,815.