China's reforms have opened a £23.7-trillion opportunity for foreign investment managers. To succeed in this intricate market, foreign firms should devise segment-specific strategies, alternative data capabilities and collaborate with online wealth platforms.
With the Chinese government set to lift restrictions on foreign ownership of fund management firms in 2020, many investment managers around the world are looking to China as their next big growth opportunity.2 The potential market is huge: By 2023, the country's total addressable retail financial wealth is expected to reach £23.7 trillion, with £2.6 trillion in retail assets under management (AUM) in Chinese publicly registered funds.3
But these market size statistics—enticing as they may be—don’t guarantee success for any particular firm. The future of investment management in China could largely depend on its prospects for economic growth, the reliability of regulatory reforms and the spread of cultural changes that accompany individual economic prosperity. Investment managers hoping to expand to China should, therefore, consider a host of marketplace, regulatory and cultural complexities as they establish a foothold and pursue market share. This article explores some of these complexities, aiming to arm investment management company leaders with insights to help them plan for what might lie ahead.
China’s recent regulatory reforms to encourage foreign firms to enter the investment management market, while perhaps complex, could be due to pensions. The recent relaxation of policies around foreign ownership of investment managers is part of a broader effort by the government to kerb a looming retirement savings deficit. Forecasts by the Chinese Academy of Social Sciences (CASS) predict a significant retirement savings gap developing in China over the next 30 years.4 In fact, the China pension actuarial report 2019–2050 estimates that the assets of the government-run Basic Pension System for Enterprise Employees could be depleted by 2035, principally due to an unfavourable shift in the ratio of workers to retirees (figure 1).5
China's recent regulatory reforms to encourage foreign firms to enter the investment management market could be due to pensions.
To address this anticipated deficit, Chinese authorities seem to be looking to move more of the responsibility for securing retirement income to employers and individuals. The proposed model is a three-pillar system in which state pensions (the first pillar) could be supplemented by employer-driven defined contribution savings schemes (the second pillar) and individual pension accounts (the third pillar) (figure 2). Whereas the current system is heavily reliant on the first pillar, China's recent regulatory changes appear to be aiming to spread the retirement savings load across all three pillars.
The Chinese government appears to be taking steps to encourage greater use of the system's second and third pillars. Chinese regulators have studied the significant growth of the United States' defined contribution and individual retirement account (IRA) programmes in the hope of replicating its success. The United States established 401(k) defined contribution accounts in 1981;6 by the end of 2018, 401(k) plans held US$6 trillion in assets.7 Similarly, since the launch of IRAs in 1975, IRA AUM in the United States has grown to US$8.8 trillion at the end of 2018.8
The growth of IRAs in the United States may provide a fair indication of the AUM growth potential for individual pension products in China, given the country's increasing appetite for personal wealth-building and the overall growth in investable assets fuelled by economic prosperity. In particular, just as in the United States of the 1980s, retirement investments in China may be driven by necessity. IRAs in the United States grew at a time when corporations were closing down defined pension plans at a rapid pace; the anticipated depletion of China's government pension fund could prompt similar actions among Chinese individual investors.
The growth of Individual Retirement Accounts (IRAs) in the United States may provide a fair indication of the growth potential for individual pension products in China.
China appears well placed to meet the needs of these investors in terms of fund selection. When the second and third retirement pillars were developed in the United States, the country’s unit trusts numbered about 700, many of them provided by well-respected brands.9 In China, however, there are 5,983 publicly registered funds currently and many of China’s largest investment managers have already partnered with Western firms.10
If China can replicate the United States’ AUM growth in defined contribution and IRAs, investment managers in China could have an enormous opportunity to gather retirement assets. However, while China already has some of the building blocks in place to accomplish this, encouraging people to invest and enhancing capital market efficiency will likely be a complex task.
For China’s retirement savings market to grow effectively, its capital markets likely need to mature. Recognising this, the Chinese government is taking several actions to enhance capital market maturity.
Allowing non-Chinese firms to participate in the country’s investment management activities could be one important step. Non-Chinese firms have recently been allowed to own majority stakes in investment managers with publicly registered funds and by 2020, the Chinese ownership requirement could drop completely.11 One hoped-for benefit of this move could be to put the market on a more secure, data-based footing. An opinion held by some professional investment managers in China is that rumours play too great a role in securities trading and valuation compared with Western markets, which tend to be more typically driven by data, analytics and professionalism.12
Allowing non-Chinese firms to take part in the country's investment management activities could be one important step.
Another step towards enhancing the financial markets' maturity is the government's plan to increase market-based financing. This plan has two main prongs. As the first prong, regulators are piloting a streamlined registration-based system for initial public offerings (IPOs) in Chinese markets.13 With a potential increase in IPOs, investors would have access to investments in a broader range of industries and companies. As firms work to differentiate themselves in order to raise capital, they may offer greater transparency into corporate operations, which can also reduce rumour-driven investing. The second prong restricts the offering of investment products with guaranteed returns by Chinese banks.14 This could push investors to use market-based products to build their investment portfolios, helping shift investment risk to the investor instead of the banking system.
The drive to encourage market-based products highlights a significant change regarding risk, reward and responsibility that appears to be taking place in China. Market-based products are managed and represent a shift of risk and income from the banking sector to the investment management sector. In the initial stages of this shift, most Chinese investors are opting for more money market and bond funds than equity funds.15 In fact, the current investor preference for fixed income and money market funds has recently stifled profitable growth for many investment management firms in China, as these products generate lower management fees. (A few firms, however, have seen notable success, usually driven by scale and efficiency.) As Chinese investors and markets mature, they may potentially allocate a greater share of their investments to equity funds.
Additional opportunities exist for China to encourage individual investing for retirement. For example, while the authorities have approved the launch of individual retirement products, the government has not developed incentives to participate in these accounts. Tax deferral provisions, similar to those in US retirement accounts, could likely be a next move.
An ongoing cultural shift towards an investing mindset is likely to further accelerate the adoption of IRAs. Even China's mass retail segment appears to be developing an investing mindset, as the country's fast-growing economy facilitates the generation of financial wealth in the largest segment of the population.16
Asset growth in China has the potential to be even more dynamic than was the case in the United States, given seemingly strong government support, continuing economic growth and the country's large population. But how much growth can be expected?
Asset growth in China has the potential to be even more dynamic than in the United States, given seemingly strong government support, economic growth and its large population.
To ascertain, we constructed a model to calculate China's prospective retail financial wealth. For the objectives of the model, Chinese investors were divided into four segments based on the wealth they possess: mass retail, cream of mass retail, mass affluent and high net worth individuals (HNWI). Of these, the last two segments were considered analogous to Western market segments.
This report is based on insights gleaned from on-the-ground discussions with two regulatory bodies and senior executives of a dozen investment management firms in China. We supplemented these insights with a quantitative model that forecasts retail financial wealth using GDP as the explanatory variable. Each investor segment's assets in public funds are assumed to be proportional to the financial wealth they hold. The bottom 20 per cent of the population is assumed to own no financial wealth.
Figure 3 illustrates the model's forecasts under four different assumptions for real GDP growth, which is the major driver of these asset growth forecasts. The “base” scenario assumes that China’s GDP will grow by an average of 5 per cent annually over the next five years, as our models point to this growth rate as the most likely. (We recognise that China’s GDP has grown at an annual average of 6.9 per cent over the past five years. However, as economies get larger, it is typically harder for them to maintain growth levels as high as China has recently experienced.) This base case estimates that retail AUM in Chinese public funds could nearly double to US$3.4 trillion by the end of 2023.
Under different GDP growth assumptions, the model’s forecasts alter accordingly. In our extreme “bear” case of zero per cent GDP growth, the forecast predicts that public fund AUM will decrease slightly, standing at US$1.7 trillion in 2023. On the other hand, if China’s GDP averages 6 per cent growth through 2023, public fund AUM is expected to grow to US$3.9 trillion.
We also modelled asset growth among the four Chinese retail investor segments. Our analysis suggests that each segment will experience healthy asset growth between now and 2023. The highest absolute growth is expected in the mass affluent segment, which could become the largest segment by financial wealth by 2023 (figure 4).
The private fund market is a bit different. Since China has a qualified investor rule, the retail market for private funds comprises HNWI investors alone. This market is even more fragmented than the public funds market, with more than 24,000 private fund managers currently competing for £1 trillion in AUM17 (figure 5). This space could be ripe for consolidation as branded, well-capitalised firms enter the marketplace with efficient operations and scale.
AUM in private funds could have a growth rate similar to that of public funds in the base case and may reach nearly £2 trillion at the end of 2023 (figure 6). This growth rate is faster than that of China’s GDP in this scenario, as investors across segments could allocate more of their wealth to financial assets.
To summarise, the future could be rosy for Chinese investors - thanks, in no small part, to the Chinese investment management industry's progress towards the development of an investment culture, even before the recent reforms. China's investment management industry didn't appear overnight. It comprises nearly 6,000 publicly registered funds that have amassed £1.5 trillion in assets as of June 2019.18 China's policy changes - including the shift to the three-pillar retirement system along with reforms to capital markets and foreign investment management firm participation - may further unlock the potential of the country's large, existing pool of investments by supplying them with much-needed AUM. Higher industry AUM levels can enable firms to reinvest in asset-gathering, potentially creating a virtuous circle of retirement savings.
Higher industry AUM levels can enable firms to reinvest in asset-gathering, potentially creating a virtuous cycle of retirement savings.
Will these reforms alter the course of retirement savings enough to reduce or eliminate the retirement savings gap in China? They certainly encourage movement in the right direction. Most notably, our projections for growth in retail AUM in both public and private funds far exceed the current balance of China’s government pension fund. A change of this magnitude will likely make a difference in the long-term path to retirement savings.
To succeed in the Chinese investment management market—with “success” defined as profitably raising AUM—firms should understand the Chinese market and investors’ mindsets and expectations and formulate their strategies and offerings accordingly. Here are some steps they can consider:
Double down on segment-specific tactics. In the Chinese retail market, segment-specific tactics can potentially drive success to a greater degree than in Western markets (figure 7). For example, for firms serving the HNWI and mass affluent segments—which, together, are expected to have US$2.1 trillion AUM in public funds and US$1.5 trillion AUM in private funds by the end of 2019—the avenues to success may be similar to what works in the rest of the world. Investor preferences among the Chinese HNWI and mass affluent segments are subtly different from those of Western investors, but the distribution points to connect with them are similar. On the other hand, the scale of the Chinese mass retail segment, which includes more than 600 million people, dictates a highly segment-specific approach. Profitably reaching that many investors might call for tactics unique to the Chinese market.
Worth a special mention are the cream of mass retail and mass retail segments, which currently represent an approximately US$300 billion opportunity in public funds AUM. Finding a solution for these two segments is likely more important than this US$300 billion figure might dictate on its own. The cream of mass retail and mass retail segments represent approximately 750 million people and their well-being in retirement is an important consideration. Helping them invest to achieve their retirement goals is what may be largely motivating investment reforms in the first place. If this is so, then foreign firms that include these segments in their strategic approach are likely to be playing in the solution space that will bring them the most goodwill in the region.
Firms may also benefit from taking a longer-term view of the mass retail and cream of mass retail segments’ profitability potential, even though they might not command the highest margins today. In particular, firms targeting these two segments have an opportunity to control shelf space and build relationships with potentially hundreds of millions of investors through defined contribution platforms (the second pillar). It is quite possible for the second pillar to be a farm system for the next generation of affluent investors. Several firms in Western markets, in fact, have successfully used this strategy to gather assets with low-balance workplace investors through defined contribution platforms.
Firms targeting the cream of mass retail and mass retail segments have an opportunity to control shelf space and build relationships with hundreds of millions of investors through defined contribution platforms.
Partner with established Chinese e-commerce platforms. China has a unique opportunity with the cream of mass retail and mass retail segments, in terms of the number of investors, ticket size and investment preferences. Gaining access to these segments likely requires a low-cost approach. Fortunately, there are several fund distribution platforms in China with the scale and reach required to efficiently provide investment management services to these segments. Because creating a new, competing platform in China might not be feasible for many investment management firms, investment managers planning to serve these segments should consider seeking placement on these established platforms. The scale of these networks makes possible a favourable combination of customer acquisition cost, recurring customer income and ongoing account-based costs. Hence, placement on these platforms could be an investment manager’s best opportunity to tap into the third pillar of retirement savings for Chinese mass retail and cream of mass retail investors.
That said, a defined contribution platform could be feasible, servicing the same retail segments through the workplace. Since defined contribution platforms are investment-focussed and limited in scope compared with e-commerce platforms, an adapted Western platform may be an effective approach to bring this capability to China. Tight coordination with Chinese regulators will likely be key to success in this closely watched, developing retirement savings avenue.
Deliver on investors’ risk-and-return portfolio expectations. One success factor addresses the possibility that Chinese investors, who are known to be risk-takers, may benefit from a greater appreciation for professional risk management in investing. Chinese investors may need more and different guidance on determining the appropriate level of risk and the relationship between risk and expected returns. The investment managers most likely to succeed will likely be those that support these investors in shaping their behaviour to optimise their portfolios for risk and reward.
Base investing decisions on alternative data. Meeting Western investors’ risk and return portfolio expectations is difficult enough. In China, it will likely be even harder, as firms must consider factors related to the reform process and the accompanying maturation of both Chinese investors and capital markets. Further complicating the picture, the markets in China are often considered less efficient and transparent than Western markets. And as is widely recognised, macroeconomic reporting in China is largely directional and indicative, but sometimes lacks precision.19
To account for these factors, investment management firms in China should consider building internal capabilities to measure economic and corporate activity in addition to analysing secondary research . Successful managers in China will likely develop proprietary insights with privately sourced or even proprietary data. Alternative data capabilities to measure consumer, corporate and macroeconomic activity could thus be more critical than in Western markets. (Firms are leveraging alternative data like satellite imagery, freight traffic and discretionary spending as they try to outperform market benchmarks.)20 Firms that depend on analyses fuelled solely with secondary research and widely reported data are less likely to be successful.
Successful managers in China will likely develop unique insights with privately sourced or even proprietary data.
Take advantage of market inefficiency. The first wave of foreign investment managers in China have an opportunity to improve market efficiency by developing mechanisms that create the economic insights needed to manage portfolios in queue with investor expectations. As the markets mature and more trading decisions are backed by robust institutional analysis, investors in these early established portfolios stand to reap the rewards and lead the way in China’s nascent, rapidly-developing capital markets.
Investment managers have a unique opportunity to expand their global reach into China in the next year or two . While there are undoubtedly many paths to success, all players in China’s complex investment management market will need to find innovative ways to understand and serve this complex, burgeoning market. Firms that move boldly with well-formulated, segment-specific market entry strategies have the chance to capture a lasting advantage.
The Deloitte Center for Financial Services, which supports the organisation's US Financial Services practise, provides insight and research to assist senior-level decision-makers within banks, capital markets firms, investment managers, insurance carriers and property organisations. The centre is staffed by a group of professionals with a wide array of in-depth industry experiences as well as cutting-edge research and analytical skills. Through our research, roundtables and other forms of engagement, we seek to be a trusted source for relevant, timely and reliable insights.