Take China's QDII ETFs with a pinch of salt

If Shanghai Stock Exchange's general manager, Zhang Yujun, is to be believed, China's new generation of exchange-traded funds under the qualified domestic institutional investor (QDII) scheme will be ready for launch shortly.

The Shanghai bourse is keen to put its hotly anticipated products onto the market as soon as possible. It has marked 2010 down as a year of innovation, with the number of domestic and overseas ETF launches potentially hitting 10 for this year.

But it's not the domestic ETFs that industry execs in Shanghai or around the region are buzzing about, but the overseas ETFs the SSE is championing. Market players are wondering what the developments will mean for the QDII market and what China's fund flows in the region will look like after these products are made available.

The names now lining up in the QDII ETF pipeline include: China Southern, with its planned launch of a S&P 500 tracker; Beijing-based China Asset Management, which is going with Hong Kong's Hang Seng Index; Harvest Fund Management, the new proud owner of Deutsche Asset Management's Asian investment platform, using the Dow Jones Industrial Average; Shanghai's Fortune SGAM, which will soon see its foreign stake transferred to Société Générale's alternatives arm, Lyxor, and whose ETF tracks the Topix Core 30; not to mention Huaan's newly announced initiative to track the FTSE 100.

In one fell swoop, the SSE is making available assets from around the world. Investors in China, at the click of a trade, will be able to access asset classes from US and UK equities to regional Asian exposures and Hong Kong and Japanese stocks.

(The list above does not cover Guotai Fund Management, one of the earliest Chinese houses wanting to license an index for an overseas ETF, which recently realised it will not attract enough liquidity for a niche index such as the Nasdaq 100. It is now quietly calling its product an "index-tracking fund", instead of an ETF. Nor does the list include Penghua Fund, whose high-profile announcement of its supposed deal to have contracted three MSCI Barra indices was never confirmed by MSCI.)

Zhang says the Shanghai bourse wants to play its part in 'standardising' asset management. Index-based products are easily understood by investors, and through the standardisation process, the SSE believes it will bring transparency and even discourage moral hazards among asset managers.

Better yet, since trading and management fees for ETF instruments are traditionally the lowest for products globally, the introduction of ETF competition into the Chinese market should help bring down the high fees usually seen in the active management sector. And the way Zhang sees it, passive and index-based investments will eventually outperform.

Yet all these laudable ambitions should be taken with a pinch of salt. Far from having developed ETFs that come up to expectations, the SSE's versions of these products and the underlying mechanism are hardly on a par with developed-market ETFs.

In particular, sources say the SSE boss's comments are meant for domestic consumption -- the exchange has been publicly pressuring the China Securities Regulatory Commission (CSRC) into approving the ETF launches, which were planned to have happened as early as November last year.

Why the regulatory hesitation? The CSRC was an early champion of introducing more liquid and transparent ETFs to China. But the SSE has not resolved the multiple technical barriers limiting the listing of an efficient overseas product in the country, as is revealed by an early blueprint for the Harvest Dow tracker jointly designed by Harvest and the SSE, and made public by the exchange. The SSE has made compromises in the design and the trading mechanisms of these supposed ETFs.

Amid the fanfare created by the issuing fund houses and even the SSE itself, one key point appears to be overlooked. The unspoken truth is that since the bourse has failed to tackle the underlying issues, the planned ETFs could only trade on exchanges as closed-end funds and would largely fail to deliver the many benefits normally expected of genuine ETFs.

These products will face challenges from day one, including: time differences in settlement cycles between the SSE and the exchange of the underlying index's traded market; the lag in trading hours between China and underlying securities; the limitations of China's lack of market-making mechanisms, and its reliance on its unique arbitrage mechanisms for levelling ETF traded prices and net asset values; and China's foreign exchange restrictions, which currently only allow for monthly repatriation of capital. All of which the SSE has acknowledged in its white paper on ETFs that is available to the public.

Bound by these limitations, these products will not be able, for example, to perform continuous creation of units like normal ETFs, unlike even the very same strategies traded in Hong Kong. The NAVs will be largely static during the trading hours in China, though the ETF prices will be subject to supply-demand swings. (Hong Kong's platform is backed by market-makers, unlike Shanghai's, which is highly sensitive to liquidity and the level of trading among arbitrageurs on underlying strategies.)

The question then becomes: will China ever attract enough interest among arbitrageurs to trade on these faraway markets without real-time information? After all, when China trades, the US and the UK markets will be largely closed. Even for markets that sit in Asian time zones and close at hours overlapping China's, there will be time differences on the settlement cycles. Arbitrageurs, therefore, will have to trade by assuming and incurring all risks themselves.

For example, a Ping An Hong Kong subsidiary doesn't trade on the books of Ping An's mainland entity. Legal status still withstanding, they are very different entities. One unit south of the border going short, cannot be reconciled from an accounting perspective by a separate unit going long north of the border. So, from where and how will these arbitrageurs emerge?

Because of the many compromises the Shanghai bourse has made to fit QDII ETFs into the existing -- but highly unique -- domestic ETF mechanism, the forthcoming international instruments can largely only be ETFs in name but not substance. An even better way to understand them is actually to see them as the equivalent of 'listed open funds' or 'Lofs' -- products peculiar to China.

Ultimately, QDII ETFs are no different from closed-end funds -- so why the current fuss over them? Sources close to the Shanghai bourse's advisory panel say there's really no reason for it -- they are just another group of products to add to China's well stocked shelf.

Nonetheless, they offer a slightly better alternative to the many internally managed and largely cost-return-inefficient QDII active funds now available in the market. And the idea of ETFs from a marketing perspective will no doubt catch on.

But even the mere illusion of innovation in the QDII market may be a false dawn. Both active and passive QDII managers will continue to be plagued by domestic expectations of further renminbi appreciation and by the bad reputation of the first generation of QDII products still freshly and firmly fixed in the minds of Chinese investors.

To wit, E-fund -- the second biggest Chinese fund house, no less -- kicked off the year with a fundraising attempt of just $86.6 million for its first QDII product.