Liberalising fund management

The fund management industry has been at the forefront of the broader liberalisation of the Chinese capital markets. Its position has been further strengthened by the new rules of the China Securities Regulatory Commission (CSRC), including the Measures for the Administration of the Operation of Publicly Offered Securities Investment Funds (公开募集证券投资基金运作管理办法) (Measures) and the Provisions on Issues Relevant to the Implementation of the <<I>Measures for the Administration of the Operation of Publicly Offered Securities Investment Funds> (关于实施《公开募集证券投资基金运作管理办法》有关问题的规定) (Provisions), which revise the investment funds regime as of August 8 2014. These new rules apply to “public investment funds”, which generally need to have at least 200 subscribers; a minimum size of Rmb200 million; a minimum total of 200 million fund units; and a scope of permitted investments that is restricted to quoted securities and other forms of securities and derivatives determined by the CSRC, which have, in practice, included stock index futures and certain money market derivatives.

The reforms are underpinned by the recent focus of the CSRC's policy to allow a greater range of investment institutions (including securities companies, insurance asset management companies and private equity houses) to compete with traditional fund management companies in managing public investment funds, whilst at the same time expanding the range of products traditional fund management companies may offer as well as the range of protection and choice for investors.

Among other things, the key changes introduced by the Measures and the Provisions include:

• putting in place a ready to go funds registration regime;
• introducing the concept of a fund of funds (FOF) and relaxing regulation of funds operations;
• enhancing liquidity by broadening the trading platform for public investment funds;
• imposing additional requirements to align portfolio selection with investment objectives and control risk, while also encouraging diversification; and
• introducing new related party transactions requirements.

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Developing the funds registration regime

The PRC Securities Investment Fund Law (中华人民共和国证券投资基金法), which was last revised in late 2012, replaced approval with registration for public investment funds. The new rules generally improve the registration regime, highlighting that the focus of the CSRC's review of new funds registrations will be on completeness of the submissions and compliance with the relevant laws and regulations. While the previous prohibition of new fund products similar to the manager's existing products is removed, there are additional requirements for, among others, the preparation of the fund prospectus and checks on investor suitability in order to determine whether a public investment fund can be successfully registered. For products capable of more standardisation, such as equity, bond, hybrid, index and money market funds, simplified registration procedures may apply and could be as short as 20 business days (though in practice, the CSRC may take longer). In line with these changes, the CSRC has clarified that limits on the number or timing of funds that a fund manager can launch will no longer apply.

These developments in the registration regime are accompanied by new powers that enable the CSRC to better address non-compliance through the funds registration process. Firstly, if a fund manager or custodian breaches the new rules, the CSRC can call the fund manager or custodian to account, including by refusing their applications to raise investment capital until the issues are rectified. Secondly, if there are inconsistencies in the materials submitted or discrepancies in the factual descriptions included in a fund registration application, the CSRC can suspend the application and refuse to entertain any new submissions from the same fund manager for six months. In more serious cases where the materials submitted are untrue or misleading, the CSRC can refuse or revoke the registration of the funds.

First-ever FOFs

Before the Measures were issued, securities investment funds in China could only invest directly in stocks, bonds and other securities, although the Securities Investment Fund Law contemplates further rules permitting funds to invest in other funds. The Measures, for the first time, permit the establishment of fund of funds, which are required to have at least 80% of the funds' total assets in other funds. The maximum amount that a FOF can allocate to a single fund is limited to 20% of its net asset value. A FOF is prohibited from investing in another FOF.

A fund which is not a FOF is now also permitted to invest in other funds. However, the maximum amount that can be invested by a non-FOF fund in other funds (except money market funds) is limited to 10% of the investing fund's net asset value.

These developments enable funds investors to achieve greater diversification. It appears, however, that the CSRC is not yet accepting the registration of new FOFs. Further guidance is awaited on issues such as:

• whether FOFs can only invest in external funds or if they may also invest in other funds under the same fund manager (one possibility is that, if FOFs are allowed to invest in other funds managed by the same fund manager, the investment could be subject to additional compliance requirements on related party transactions);
• the criteria with which a FOF's underlying fund investments need to comply;
• the mechanism for FOFs to exercise their rights as unitholder of the underlying funds they invest in; and
• whether FOFs can require the investors to bear the FOF's fees as well as those charged by the underlying funds before fund managers can fully take advantage of the new rules to invest their capital in other funds.

As a possible point of reference, the additional guidance could be based on the rules of other developed jurisdictions such as the Hong Kong Securities and Futures Commission's Code on Unit Trusts and Mutual Funds, which provides more detail on the parameters within which a fund can invest in another fund managed by the same manager, the extent to which the fees and charges of the underlying funds can be passed through to investors and the scope of investments of the underlying funds.

Wider range of products

The further development of a market-driven fund management industry is high on the CSRC's agenda. The rules regarding a fund's establishment and operation have been relaxed and the range of possible products broadened. For funds with no less than Rmb10 million invested by the fund manager, its related entities and individuals, the previous requirements on minimum fund size and number of investors have been removed, making it possible to set up a new type of fund with fewer than 200 unitholders. This is expected to facilitate the setting up of more tailor-made funds to suit smaller groups of investors.

For the first time, the Measures expressly set out the principles for public investment funds to invest in derivatives, indicating that public investment funds will be able to apply various risk management techniques (including by entering into derivatives transactions) to manage exposure, subject to detailed rules to be issued in the future. So far, public investment funds are permitted to hedge their investment risks only in very limited circumstances.

The CSRC is further expected to develop rules for real estate funds and commodity futures funds, for which no implementing rules have yet been published. For example, the CSRC recently issued a consultation paper on investment in exchange-traded commodity futures by exchange-traded funds (ETFs) in its Guidelines for the Operation of Publicly Offered Securities Investment Funds No.1 (Draft for Comments) (公开募集证券投资基金运作指引，第1号（征求意见稿）) on August 29 2014. This would allow the development of ETFs using exchange-traded commodities futures contracts to track the prices of commodities futures or the value of a commodities index.

Enhanced liquidity

Before the Measures were issued, market-based trading of units in investment funds could generally only take place after a PRC stock exchange had accepted an application for the fund to be admitted to trading. According to the website of the China Securities Investment Funds Industry Association, there were altogether 1,759 securities investment funds as of August 29 2014. However, the number of securities investment funds currently listed on the Shanghai and Shenzhen stock exchanges (including ETFs) is only 65 and 327 respectively.

The CSRC now permits fund units to be traded on any exchange (not necessarily a stock exchange) recognised by the CSRC, or by other methods. This paves the way for the CSRC to prescribe further means by which fund units may be traded, such as over-the-counter trading and transfer via private agreement. It remains to be seen if fund managers will be given the flexibility to prescribe specific trading terms and methods under the fund contracts, which will be binding on their investors.

These new forms of trading, when introduced, should also make fund units a more acceptable means of obtaining financing, which the CSRC has declared to be one of its key objectives in its Opinions on Rigorously Promoting the Innovative Development of the Securities Investment Fund Industry (关于大力推进证券投资基金行业创新发展的意见), issued on June 12 2014.

Higher risk control and protection

In deregulating financial services, ensuring that risks are properly managed and investors are fully protected remain at the heart of regulators' priorities. The Measures impose additional requirements that are intended to more closely align a fund's portfolio selection with investment objectives, limit concentration on a single issuer and leverage. One significant change has been to redefine a fund's single issuer cap of 10% of net asset value to include debt as well as equity securities (not applicable to index funds or convertible bonds funds). In addition, the Measures for the first time expressly require that a fund's total assets cannot exceed 140% of its net assets (with certain exceptions such as closed-ended funds and principal-protected funds).

The Measures further tighten the regulation of related party transactions by a public investment fund by more clearly defining the types of related party transactions and the rules applicable to such transactions. The CSRC has prescribed new powers to impose fines and revoke the qualifications of the individuals responsible for these transactions if a breach is detected, so there are new incentives for fund managers to observe the new rules.

Diversification is progress

The new rules are a critical step towards a market-driven fund management industry in China, making important changes to portfolio allocation and allowing for improved liquidity, corporate governance and compliance. They highlight the CSRC's emphasis on prudent risk management of investment portfolios even as it opens up the market. Though the liberalising provisions of the new rules are largely subject to further clarification, they are likely to result in a gradual reallocation of investment priorities by existing funds, ultimately encouraging fund managers to develop products and employ investment techniques aimed at diversifying risk and reducing the industry's dependence on equity market performance. To differentiate themselves, fund managers will need to develop internal capabilities and expertise and enhance services, instead of simply relying on relationships with regulators. This will ultimately promote the advancement of the Chinese fund management industry.


Fang Jian, Bryan Chan and Jack Sun, Linklaters, Shanghai and Beijing


More from CLP:
Measures for the Administration of the Operation of Publicly Offered Securities Investment Funds
PRC Securities Investment Fund Law
PRC Securities Law (Revised in 2014)
Interview: Challenges in opening up – CITIC Capital