Investors in China warned on liquidity and valuations

UCITS fund managers with China focussed investment strategies could face major challenges around liquidity and valuation of assets if they have exposure to securities which have been de-listed or suspended from trading amid the Chinese market volatility.

UCITS have been permitted to invest in China through the Qualified Foreign Institutional Investor (QFII) quota scheme. However, the introduction of Hong Kong-Shanghai Stock Connect in November 2014 has opened up China’s equity markets even further to foreign fund managers. While Stock Connect does have investment quotas of its own, it allows for foreign fund managers to transact in Chinese A shares listed on the Shanghai stock exchange, and permits Chinese investors to gain exposure to a limited number of listed securities in Hong Kong. Both the Central Bank of Ireland (CBI) and Luxembourg’s Commission de Surveillance du Secteur Financier (CSSF) have allowed UCITS to gain exposure to Chinese equities through Stock Connect over the last year.

The market volatility in China has resulted in listed securities being de-listed and a suspension on Initial Public Offerings (IPOs) although the latter was rescinded in November 2015. Nonetheless, there are restrictions on major investors (those that own more than 5% of tradable securities) selling their shares. This could have a major impact on UCITS.
“The government’s reaction to the market volatility does present challenges. One issue would be liquidity. UCITS offers generous – often weekly or daily – liquidity terms to its investors and if a UCITS is holding onto delisted securities, this could present a problem. However, most UCITS are likely to have diversified portfolios – not one solely focused on China. Hopefully, this means it would not be a major problem to meet redemption requests,” said Richard Frase, partner at Dechert in London.

Perhaps the biggest challenge for UCITS lies with accurate valuation of assets. Valuation of de-listed securities is rife with subjectivity and the risk of error is high. Striking an accurate Net Asset Value (NAV) is crucial as it determines how much the investors pay to buy or sell units of the fund.

“Attaining fair value in such circumstances is a challenge. The UK Financial Conduct Authority (FCA) has developed fair value rules and it is crucial that managers comply with these and demonstrate best efforts compliance. Alternatively, a manager could appoint a specialist valuation agent to provide a quote. The difficulty in volatile markets is that the fair value used by a fund manager for a valuation on day one could have changed by day five. How would this impact on investors who bought on day one?” said Frase.

The issue could be given further urgency following the introducing of UCITS V, which will be implemented from March 2016. UCITS V brings about a degree of harmonisation with the EU’s Alternative Investment Fund Managers Directive (AIFMD) around areas such as remuneration. However, UCITS V is far stricter around depositary liability than AIFMD. UCITS V explicit bans depositary banks from discharging liability for any loss of assets or financial instruments to sub-custodians including CSDs (central securities depositories) and CCPs (central counterparty clearing houses).

“Like AIFMD, the new UCITS V depositary rules mean that depositaries would be on the hook should assets be lost in China, for example. The UCITS V provisions involve what is in effect a reversal on the burden of proof so the depositary must among other things be able to demonstrate that it has warned the UCITS of the issues that may arise in certain markets,” commented Frase.

There is speculation the strict UCITS V rules could deter depositary banks from working with China focussed UCITS or result in them upping their fees. There have been reports of UCITS managers facing fee increases from their depositary banks to account for the enhanced liability provisions under the fifth iteration of UCITS.

While a handful of high-profile hedge funds and private equity managers have exposure to Greece and Greek banks, very few UCITS took the plunge. The same is not necessarily true of China. As such, the events occurring in China – given its size – could present greater problems than the recent Eurozone volatility.

Stock Connect failed to gain traction at first although in spring 2015, this changed dramatically. The initial low trading volumes occurred primarily because of foreign investor concerns around the pre-funding of trades. As China and Hong Kong operate a different trade settlement time-frame for cash and securities, foreign investors would have to pre-fund trades, which exposed them to counterparty risk. Global custodians – cognisant this was inhibiting inflows into Shanghai – introduced systems to overcome the problem including Special Segregation Account models. This appears to have worked and facilitated inflows from foreign investors into China.

Furthermore, it is likely Stock Connect will be extended to Shenzhen in 2016 and a same day delivery versus payment (DVP) system could also be introduced. Some forward-thinkers even believe Stock Connect could be extended to European jurisdictions such as the UK although the time-zone differences could pose operational difficulties around settlement.