April 03,2008

Market Turns, and QDII Fund Burns

By Ma Wenluo

Awash in liquidity, individual Chinese investors are as eager to invest their money in overseas stock markets as the government is to channel excessive liquidity outside the country.  Both are looking for fat returns. But the learning curve is steep, and the process to success could be very long.


China’s Minsheng Bank, the country’s seventh largest bank by market value, has shut down a product it operated under the Qualified Domestic Institutional Investor (QDII) scheme, the first such QDII fund to be liquidated, and investor hackles have been raised.

The QDII product, the Hong Kong Fund Through Train, sold 100 million shares in October 2007 at 1 yuan (then 13 US cents) a pop. The money raised by the scheme was placed in the Baring Hong Kong China Fund. To ensure high yield and effective risk-control, a bi-directional trigger mechanism was used over the product’s one-year term. The bank would terminate the contract before the date of expiration when and if the expected proceeds were achieved or the position hit a pre-determined stop loss condition,. According to Minsheng Bank's issuance agreement, the maximum yield expected was 18 percent, and the stop loss price was set at 50 percent below initial value.

On March 19, having slipped to a net value of 49.89%, Minsheng was forced to liquidate the fund. Investors still holding the product until the expiration date of this October, hoping the fund price would rebound, got to eat their losses.

Minsheng attributed the product’s losses and liquidation to contagion from the US market slump due to the subprime-mortgage credit crisis, but most investors weren’t buying.  "The bank publicized it to be a good deal when it sold the QDII products," complained a Shanghai investor who lost 100,000 yuan on the deal. The bank’s defense on the ground of systemic risk did not raise investor spirits. "Does the bank have any strategies for risk analysis and risk management?"

Minsheng was certainly no happier than the burnt investors, but analysts agree that banks are helpless on this account. Minsheng Bank disclosed the loss and terminated the product immediately, as it had to. It announced that it would launch new QDII products at an appropriate time when the investors have a more mature understanding to the risks of this products.

And that is correct. The investors need to gain a better understanding of the risks inherent in QDII products. Mainland Chinese punters are novice overseas investors, but most retain an unrealistic confidence in high returns from overseas markets such as Hong Kong’s, just as they did in the ultra-bullish bubble A-share market of 2006-2007. But market mechanisms, investment structures and valuation levels in overseas markets are different from those of the A-share market. And then there is the global financial turmoil.

Issuers and regulators do, however, also bear responsibility. "Don’t put all your eggs in one basket?is axiomatic. Baring Hong Kong China Fund concentrated its investment on H-share Red Chips such as China Mobile, China National Offshore Oil Company, China Telecomm, China Petroleum & Chemical, and China Overseas Land. When the QDII product launched in October, the Hang Seng H-share Index was soaring above 20,000, but by the time March 19 rolled around it had fallen to 13,972. Baring’s portfolio dived even lower than the market average, though the Fund has had a superior record since it was launched in 1982.

China is facing excessive liquidity pressure due to its huge foreign exchange reserves, and Chinese regulators are eager to stick a lot of that capital overseas through QDII schemes. Regulator approval of some QDII products may well have been expedited, without taking the time to consider cross border conditions or whether the HK stock market was at a suitable spot in the business cycle.

After some bearish months, China’s QDII products seem to be recovering on the Hong Kong market, but the Hang Seng China Enterprise Index is still below the index. And Chinese investors have a long way to go and lots to learn before they make money in Hong Kong and New York.



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