How to Run Hedge Funds in a Communist Country

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(Bloomberg Gadfly) -- As global managers from UBS Group AG to BlackRock Inc. get into China’s $2 trillion investment industry, they’ll need strong stomachs to run hedge funds in a Communist country.

These lightly regulated pools, whose 1 million yuan ($158,000) investment threshold targets institutions and high-net-worth individuals, are sizzling hot. As of end-March, so-called “private securities funds” – mostly in equities and funds of funds – commanded 2.6 trillion yuan of assets, up from less than 1 trillion yuan three years ago. The actual total is probably a lot higher: At least 10,000 funds are illegally raising money because they’re not registered with the Asset Management Association of China.

No financial product can flourish without Beijing's implicit blessing. Last October, China passed sweeping rules to curb risks in the financial system, whose notorious shadow banks offered wealth-management products that were perceived as risk-free. By letting mutual funds and hedge funds multiply, China is shifting to a healthier model like that in the U.S., where investors understand returns are compensation for risks taken.

Beijing wants outside help to shift the free-lunch attitude. As of March, six foreign managers had started such private funds, data compiled by Cerulli Associates show. Even Vanguard Group Inc., whose core offering is low-cost mutual funds, is now weighing a launch.

Billions of dollars are up for grabs. According to China Merchants Bank Co., the number of individuals with more than 10 million yuan in disposable assets reached almost 16 million in 2016, with total investable assets touching 58 trillion yuan in 2017. 

But as usual in China, things can go awry.

In the country where a hundred flowers can bloom, a lucrative field will be flooded by hundreds of newcomers. As of March, there were more than 8,000 private securities fund managers offering 35,000-plus products in China. How will UBS, Shroders Plc and Neuberger Berman Group distinguish themselves?

Also, prized institutional investors like pension funds might be hard to attract, because they usually require managers to have at least a one-year track record. The foreigners, having launched late last year, will therefore need to rely on wealthy individuals who can be finicky, and still have expectations of guaranteed returns. 

Witness the controversy over First Seafront Management Ltd., which has around 100 funds and oversees 54 billion yuan of assets. 

In March 2015, the firm co-launched a fund of funds for New Third Board stocks – high-risk, low-liquidity shares traded over the counter. When the fund closed last month with a large loss after three years, some investors revolted, staking out First Seafront’s offices with banners demanding management “return my hard-earned money.” 

The underperformance wasn’t surprising: The New Third Board index dropped 50 percent in that three-year period. Some investors are now insisting the firm hand over an 8 to 10 percent annualized return, according to local media reports. 

The public protest is reminiscent of the tactics investors used in 2014 to get their money back from a wealth-management product distributed by Industrial & Commercial Bank of China Ltd. On its website, First Seafront asked people not to be carried away by emotion, reminding them that “high-risk stock investments cannot be done with a guaranteed-return mindset.”

Global managers can pitch to me again and again that China’s new wealthy are becoming more sophisticated and more reasonable about returns. The truth is, they’re not. After all, the bar for high net worth is not especially high – an individual with financial assets of at least 3 million yuan, or an average annual income of at least 500,000 yuan over three years, can invest in private funds.

For UBS or Schroders, this is the first inning in a long game. To win, they may need to weather some ugly populist backlash.

Shuli Ren is a Bloomberg Gadfly columnist covering Asian markets. She previously wrote on markets for Barron's, following a career as an investment banker, and is a CFA charterholder.

©2018 Bloomberg L.P.

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