A Firsthand Look into the QDII Program

Robert Hsu, December 01, 2007

While in China, our tour group visited fund manager John Yen at the Hong Kong offices of China Merchants Securities, one of Mainland China's leading brokerage and fund management firms. Formerly a portfolio manager at insurance giant Aetna in New York City, John was hired by China Merchants Securities to manage their new QDII mutual fund.

As you may remember, QDII stands for Qualified Domestic Institutional Investors. The QDII program was started by China's government earlier this year. It allows brokerage houses like China Merchant Securities to create mutual funds that invest in foreign stocks. More that $15 billion has been raised for these mutual funds, and demand continues to be strong for new funds. QDII is one of the main investment themes we've been following here at China Strategy, so our group went to see John Yen to find out more about what's going on with the program.

John's office at China Merchants Securities is located on the 48th floor of One Exchange Square. The newly-opened office happens to be directly above the Hong Kong Stock Exchange. Even though China Merchants Securities is one of Mainland China's top securities brokerage firms, it didn't have a Hong Kong branch office until last year. Most of the firm's clients in Hong Kong are Mainland Chinese retail customers who have funds in Hong Kong.

Although China's direct investment pilot program was put on hold last month, there is already a lot of Mainland Chinese money in the Hong Kong market. Mainland investors need to set up an account in Hong Kong and fund it with Hong Kong dollars in order to trade there.

There is a popular misconception that Mainland Chinese are not allowed to own stocks outside of China. Mainlanders can in fact own stocks outside of China, but the hard part for investors is acquiring the large amount of foreign currency it takes to buy stocks.

Currently, the limit for a Mainland citizen buying foreign currency amounts to only $50,000 U.S. dollars per person each year. Many investors buy foreign currencies under the names of friends and relatives to get around this rule. A Mainland Chinese investor who wants to invest $100,000 USD in foreign stocks can buy $50,000 in Hong Kong dollars under his own name and another $50,000 under the name of a nominee. Many Mainland Chinese investors, especially ones in southern and coastal Chinese cities, send money out to Hong Kong and invest abroad. China Merchants Securities' Hong Kong branch has more than 20,000 retail client accounts established mostly by Mainland Chinese investors.

The History and Structure of QDII Funds

Our tour group was greeted at the reception area of China Merchants Securities by Jack Tsui, an institutional sales manager at the firm. Jack led us to a conference room with a large balcony and a beautiful view of the Hong Kong skyline. Our group rushed out on the balcony to take pictures while I chatted with the new QDII fund's portfolio manager, John Yen.

John was born in Taiwan and went to the U.S. for his MBA. He spent more than a decade in New York working for insurance giant Aetna as a portfolio manager. Taiwanese-trained money managers like John manage most of the newly formed QDII mutual funds that raise money in Mainland China to invest abroad.

Taiwanese dominate this area because global funds have existed in Taiwan for over a decade, and Taiwanese portfolio managers have professional experience managing international investments. In addition, Taiwanese fund managers can communicate better with Mainland colleagues in Mandarin than most Hong Kong professionals.

John gave our group an enlightening presentation about the history of QDII funds, and we learned that China's leading fund management companies have formed the first four QDII mutual funds in the past two months. Following fund management firms, brokerage firms have received permission to form new funds as well. China Merchants Securities is the second stock brokerage firm in China to receive permission to establish a mutual fund that invests outside of Mainland China.

Each fund is scheduled to raise between $2 billion and eventually up to $5 billion. Unlike other global mutual funds in China, which charge a straight 3% annual management fee, John's fund has a fee structure similar to hedge funds. Investors pay a 1.5% annual management fee plus an additional 12% of all profits gained by the fund above a 5% hurdle rate. Unlike most hedge funds, however, John's fund is a long-only fund, which means that he can only buy and sell securities and not sell anything short.

The investment strategy of John's QDII fund is similar to multi-strategy asset allocation funds in the U.S. Currently John plans to invest 60% of the fund's assets in Hong Kong and the other 40% abroad. In Hong Kong, the fund will invest in many of the same large Chinese companies that we own. Click here to register and to find out which companies are a part of our China Strategy portfolio.

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Most of the funds invested outside of Hong Kong will be in sector and country ETFs, though there will be a few individual stocks in the portfolio. Our group members asked John about his favorite U.S. stock picks, and he named Google as well as Apple (NASDAQ: AAPL).

The approach John is using focuses more on sector and asset-allocation strategy rather than selecting individual stocks. I asked John whether the fund he manages will invest in Chinese companies listed abroad, such as Ctrip (NASDAQ: CTRP) and Mindray. John said that they will probably not invest directly in individual Chinese shares, but instead invest in a basket that contains several of these stocks. As much as he likes Apple, John explained, he will not be able to buy a large amount of the stock for the fund. John added that each QDII fund is different -- certain funds focus on stock picking while his emphasizes asset allocation.

Our visit with John was very educational. China Merchant Securities' new fund manager certainly impressed our group. I was a bit disappointed to learn that these funds might not buy as many Chinese entrepreneurial companies listed in the U.S. as I had expected. Nevertheless, these funds will still buy our stocks and create another source of momentum behind them. QDII funds will also fulfill investor demand in China and help curb some of the speculative pressure that's building there.

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