Exchange Thoughts Brown Brothers Harriman s ETF Newsletter

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1 Brown Brothers Harriman s ETF Newsletter Chinese ETF Launches in US and Europe Signal New Opportunities Introduction... 3 Developments in the RQFII Space... 4 Routes to Market: Local Partner or Independent?... 5 Key Considerations and Need for ETF Expertise... 5 What s Next?... 6

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3 Welcome to, BBH s ETF Newsletter INTRODUCTION China s capital markets have entered a period of dramatic liberalization, enabling asset managers to offer investors new products with exposure to this once elusive market. Regulators have relaxed certain market restrictions, including but not limited to: The Qualified Foreign Institutional Investor (QFII) investment quota ceiling was increased to $150 billion from $80 billion in December The Renminbi Qualified Foreign Institutional Investor (RQFII) quota allocation that was previously granted to each individual fund is now granted to the manager and allows quota to be shared across multiple funds. platform in November Both facilities provide investors greater access to investment in mainland China without impacting their quotas. The RQFII ETF space is rapidly evolving and Brown Brothers Harriman (BBH) has created this edition of in order to help you understand recent developments in the space, as well as the background and context of these products. If you would like more information on how these products work, or if you are interested in understanding how BBH can support these new structures, please contact us at: Reports suggest that China Interbank Bond Market (CIBM) restrictions on foreign investors will also soon be relaxed in terms of eligibility, scope of investment, and quota management. The Shenzhen-Hong Kong Stock Connect is expected to launch as early as fourth quarter 2015 following the implementation of the Shanghai-Hong Kong Stock Connect Americas: Muy Chan muy.chan@bbh.com Americas: Vivian Tung vivian.tung@bbh.com Europe: Andrew Craswell andrew.craswell@bbh.com CHINA S INVESTMENT SCHEMES QFII RQFII QDII Foreign asset managers can invest in China A-share market through US Dollars or other foreign currencies; investment is subject to a quota. Foreign asset managers can invest in China A-share market through offshore renminmi (RMB); investment is subject to a quota. Local Chinese asset managers can invest in global capital markets through securities and mutual fund investment. 3

4 DEVELOPMENTS IN THE RQFII SPACE Since its launch in 2011, the RQFII program has undergone significant developments with the expansion of its product offering, quotas, and geographic scope. Indicators of investor appetite and market opportunity can be seen in frequent new product launches in the US and Europe such as the CSOP FTSE China A50 ETF (NYSE Ticker: AFTY) and BlackRock s ishares MSCI China A UCITS ETF (LSE Ticker: CNYA) which represent innovation in product offering and market-entry approaches. AFTY is the first RQFII product listed in the US by a Chinese asset manager without collaborating with another global asset manager, while the latter is the first UCITS product listed in Europe by a western asset manager without collaborating with a Chinese asset manager. This trend of entering the market directly without a partner is an indication of increasing maturity and brings its own unique challenges for an asset manager. Prior to RQFII ETFs, foreign investors could only access the market through offshore mechanisms, such as ADRs and GDRs, derivatives, or offshore shares of mainland China-incorporated companies trading in Hong Kong. These market access challenges created a significant demand for mainland exposure via physical products, such as RQFII ETFs, which attempt to achieve a physical representation of the underlying index by directly investing in mainland A-shares in order to replicate its composition. As part of China s increasing liberalization of the financial market, the Shanghai-Hong Kong Stock Connect platform was launched in November 2014, providing investors with another platform to more easily access a portion of mainland China A-shares without requiring RQFII or RQFII license. Through this platform, Hong Kong brokers can offer clients shares of eligible companies traded on the Shanghai Stock Exchange. Meanwhile, Chinese brokers can offer clients shares of select stocks that are traded on the Hong Kong Stock Exchange. The platform often serves as a complement to an asset manager s investment strategy in China without potentially impacting their RQFII or RQFII quota, which can be reserved for those securities not available through the Stock Connect platform. In March 2015, CSOP Asset Management Ltd launched the first RQFII ETF listed independently in the United States by a Chinese asset management company. This was a defining event in the ETF space as it represents a shift in how RQFII ETFs are brought to market in the US, and underscores the increasing opportunities available with respect to Chinese investment products. Debuting with over $237 million in assets, the CSOP FTSE China A50 ETF is the largest initial capital investment of all US-listed equity ETFs since It is also worth noting that CSOP s RQFII quota of approximately $7.4 billion far exceeds an asset manager s average quota of approximately $330 million. 2 Asset TV Video: Capturing China s Growth Shawn McNinch, Global Head of ETF Services at BBH and Curtis Tai, ETF Strategist at CSOP Asset Management discuss how foreign investors can gain exposure to China s onshore growth. December 2011: Launch of RQFII Program Enables holders of RQFII quotas, such as qualified financial ins tu ons, to raise funds in Hong Kong for the purpose of directly inves ng into mainland China s securi es market November 2012: Quota increased to 270 billion RMB Though the RQFII program began with a rela vely modest quota of 20 billion RMB, it has since increased drama cally in size to over 270 billion RMB November 2014: Launch of Shanghai-Hong Kong Stock Connect Pla orm Foreign investors can access designated stocks listed in Shanghai via Hong Kong May 2012: RQFII Program Expands RQFII program expands with launch of ETFs March 2013: CSRC relaxes RQFII requirements CSRC lowers RQFII entry requirements, simplifies approval process and expands scope of RQFII investment July 2013: Geographic Scope Expands Includes quotas for asset managers in countries such as Taiwan, Singapore, South Korea, the UK and Germany 4

5 ROUTES TO MARKET: LOCAL PARTNER OR INDEPENDENT? RQFII ETF launches by US and European managers have historically occurred in conjunction with local Hong Kong-based Chinese asset manager partners to leverage their RQFII license and quota approvals, as well as market expertise. For example, the Deutsche X-Trackers Harvest CSI 300 Index ETF was the first RQFII ETF listed in the US by Germany s Deutsche Asset & Wealth Management in collaboration with China s Harvest Global Investments. Others soon followed suit including the KraneShares Bosera MSCI China A Share ETF, Global X GF China Bond ETF, and Market Vectors ChinaAMC China Bond ETF, offering investors a diverse product range with access to China s onshore equity and bond markets. This type of partnership offers many benefits such as: Established distribution platforms Brand recognition Operational leverage Market expertise Mutual advantage in navigating the regulatory landscape Recently, asset managers have begun launching and listing RQFII ETFs in the US and Europe without collaborating with another partner. Operating independently offers certain benefits such as fewer contractual burdens, the ability to drive one s own strategy, and leverage existing operational design. However, there are certain challenges with this approach. A Chinese asset manager launching products in the US or Europe may face difficulties understanding the local regulatory environment, fund and reporting requirements, investor behavior and distribution dynamics, as well as operational coverage. A western asset manager launching RQFII ETFs independently will likely encounter challenges from a local market practice and investment perspective. KEY CONSIDERATIONS AND NEED FOR ETF EXPERTISE Market Entry and Product Structure At present, funds launched in Europe and the US must clear both local and Chinese regulatory hurdles. Applications for Chinese RQFII license approval must be submitted to the China Securities Regulatory Commission (CSRC), after which a decision may be granted within 60 days. Following this, State Administration of Foreign Exchange (SAFE) grants approval of a quota allotment within a further 60 days. Meanwhile, an additional approval is required for fixed income products from the People s Bank of China. For Chinese asset managers seeking to launch US-domiciled products without a western partner, there are additional considerations and set up costs. For example, managers must decide on the type of product structures (1933 vs Act), establish a trust, and hire various external parties such as legal and tax advisors. US regulators also require funds to file for exemptive relief. For EU domiciled products, choosing the ETF domicile is a key consideration. Ireland and Luxembourg have expertise in servicing UCITS ETFs and establishing RQFII products. In April 2015, Luxembourg was granted a 50 billion RMB quota by the People s Bank of China demonstrating China s recognition of Luxembourg as one of Europe s main hubs. Both Ireland and Luxembourg offer considerable distribution accessibility as the UCITS brand continues to attract flows from across the globe. There is also increasing demand for index providers to deliver core and innovative indices across equities and fixed income asset classes. The choice of index and brand is an important element of the product development strategy. Operational Complexities The operational servicing environment of RQFII ETFs is understandably complex, involving coordination of multi-party agreements, currency conversions, and carefully calibrated timing for global processing. Challenges such as the synchronization between multiple parties (for example, the ETF sponsor, Hong Kong based RQFII subadvisor/quota holder, distributors, and other providers), or the multiple account structures needed for separate equity and fixed income investments, require careful communication and coordination. Other servicing complexities, such as currency and cash flow management, also require significant attention as detailed below: Currency Conversions: The ETF create/redeem process often requires multiple currency conversions for onshore investment, 5

6 especially in the case of US-domiciled products. Europeandomiciled funds are usually subject to fewer such restrictions; they can accept offshore RMB directly for orders, whereas the US only permits the use of US Dollars. Timing is critical, too: The execution of orders across various time zones and regimes means ETF orders and trading of the underlying ETF basket components must be properly aligned. Cash Flow and Quota Management: Quota Management can have an impact on a manager s investment strategy as it relates to potentially reaching the allotted quota. Given the currency conversions necessary for required repatriation of profits and/or investment needs, cash flow management remains a significant concern. Quota management is another consideration which can significantly hamper a fund s cash and investment management should the allotted amount be exceeded. If a manager fails to increase its quota in time, it may need to use derivative products or even limit or halt creations. This might lead to the ETF shares trading at a premium to its Net Asset Value. Further, investors could invest in a competing product if the quota is reached. We expect to see hedged products growing in popularity, particularly European-domiciled products which have fewer regulatory restrictions on currency. The European share class structure provides greater flexibility for asset managers to offer multiple currency options in a single pooled fund structure. As Chinese asset markets become increasingly mature and accessible, the need for reliable and efficient support of Chinese investment products, such as RQFII ETFs, will also increase. BBH has partnered with global asset managers to launch a diverse range of RQFII ETF products. Our expertise in servicing both physical equity and fixed income ETF products, along with our global service models in the US, Europe, and Asia, allows us to seamlessly and efficiently service many of the most onerous needs of our RQFII ETF clients, and ensure coordinated servicing and operations. 1 China Securities Regulatory Commission, QFII Quota Raised to USD 150 billion and RQFII Pilot Expanded in Singapore and London, 12 July Reuters, CNH Tracker-China Must Chop Down Regulatory Thicket to Woo Investors, Michelle Chen, January 29, China-XBR.com, New RQFII Quota March 2015, 26 March 2015 Trade Execution: Asset managers need to carefully consider the index and the replication strategy as the size of the basket will drive execution and settlement costs. From a trading perspective, liquidity can be an issue in the developing mainland China asset markets. Halted, suspended, or odd-lot securities may present challenges such as prolonged settlement cycles. WHAT S NEXT? As China s financial markets continue to liberalize, there have been exciting product developments for this market. Investors can now access China s bond market, CIBM, which offers relatively higher yields compared to US and European counterparts. This is an attractive option for many western investors seeking greater returns in a low interest rate environment. 6

7 TO LEARN MORE ABOUT BBH S GLOBAL ETF SERVICES, PLEASE CONTACT: Global Head of ETF Services: Shawn McNinch shawn.mcninch@bbh.com Europe: Antonette Kleiser antonette.kleiser@bbh.com Americas: Brian Reilly brian.reilly@bbh.com Asia: Scott McLaren scott.mclaren@bbh.com 7

8 NEW YORK BEIJING BOSTON CHARLOTTE CHICAGO DENVER DUBLIN GRAND CAYMAN HONG KONG KRAKÓW LONDON LUXEMBOURG NASHVILLE NEW JERSEY PHILADELPHIA TOKYO WILMINGTON ZÜRICH This publication is provided by Brown Brothers Harriman & Co. and its subsidiaries ( BBH ) to recipients, who are classified as Professional Clients or Eligible Counterparties if in the European Economic Area ( EEA ), solely for informational purposes. This does not constitute legal, tax or investment advice and is not intended as an offer to sell or a solicitation to buy securities or investment products. Any reference to tax matters is not intended to be used, and may not be used, for purposes of avoiding penalties under the U.S. Internal Revenue Code or for promotion, marketing or recommendation to third parties. This information has been obtained from sources believed to be reliable that are available upon request. This material does not comprise an offer of services. Any opinions expressed are subject to change without notice. Unauthorized use or distribution without the prior written permission of BBH is prohibited. This publication is approved for distribution in member states of the EEA by Brown Brothers Harriman Investor Services Limited, authorized and regulated by the Financial Conduct Authority. BBH is a service mark of Brown Brothers Harriman & Co., registered in the United States and other countries. Brown Brothers Harriman & Co All rights reserved. 5/2015. IS _15