Insights, The Bridge
Jason Hsu, PhDScroll down
We are not always comfortable with China’s regulatory actions. China’s regulators—working in the second largest economy in the world—make plenty of mistakes in their policy experimentation. But in most instances, those actions reflect well-intentioned people responding sensibly to difficult problems. In this article, Dr. Jason Hsu looks at a unique and recent regulatory push in China (one still not on Western radars) that is an illustration of how US and Chinese regulators are trying to tackle the same problems… but with very different toolkits.
I don’t expect anyone who reads this article—or anyone who reads The Bridge more generally—to suddenly change their views about China or its regulators. I began my journey toward a greater understanding of China with the same biases as any other US-educated and Western-centric analyst. If people are deeply uncomfortable with the scope and speed of China’s interventionist approach, let me acknowledge that I was no different. Even today, I remain cautious; though I admit, I am sometimes cautiously optimistic.
With that caveat, let’s talk about China’s regulatory policy rollouts.
I often view Beijing’s policy rollouts through two lenses: 1) the wisdom of the policy itself, and 2) the impact China’s one-party system had on the policy. I’ve rarely found the latter lens very useful. China’s political system has not changed since time immemorial; but it’s also the same system present in many emerging markets, regardless of the ostensible form of government. The optimist in me hopes the success of the Singapore model is within reach for China. That model isn’t perfect; but looking across the world, a developing economy and society could certainly do worse.
If I accept China’s political system as an exogenous given, I am left with analyzing each new policy on its own merits. I am obviously interested in the policy itself. But I am also interested—perhaps more interested—in what the policy signals about China’s direction. Is it following the path of Singapore? Or is it following a darker path?
In this article, I want to explore these questions by looking at a recent regulatory push in China around the “investor return gap.” This regulatory push is being widely debated within the country, but it isn’t even on the radar for Western media. I find these proposed regulations enlightening because it is crystal clear they are not motivated by animus.
Chinese financial market regulators have studied the US literature on the “investor return gap,” along with the broader literature on the conflict of interest in the financial services industry. The “investor return gap” describes the persistent situation where an end-investor is worse off despite receiving professional financial advice from brokers and financial advisors. Whilst mutual funds in China do outperform on average (due to significant market inefficiency), research shows that none of that return benefit accrues to the end investor.
This isn’t unique to China; the same is true in the US. Chinese mutual funds are among the very few that have outperformed US mutual funds over the last 15 years, but in both China and the US, sales load and high churning erode returns. Investors are sold one hot theme after another. As a result, they almost always buy at the top and sell at the bottom. Clients do poorly, but the fund houses, their distribution channels, and their professionals do very well. (Shameless self-promotion: Brad Cornell and I researched this topic in our Journal of Portfolio Management article, which won a 2018 Bernstein Fabozzi and Jacobs Levy Outstanding Article Award).
The problem is well understood. The real question is what to do about it?
In the United States, the “investor return gap” and the general lack of value-add from the investment management industry has generated much discussion but little action. It remains an odd “market anomaly” to economists, suggesting a potential market failure. Industry practitioners, who benefit from this anomaly, are happy to conclude the invisible hand is right in some mysterious way and they are worth the fees they charge (also in some mysterious way). The US regulator has largely counted on the market to sort things out gradually over time. After all, consumers of financial services are consenting adults; poor financial literacy is a choice. Perhaps getting fleeced is the market teaching investors a valuable life lesson and moving wealth from the financially naïve to the financially savvy; perhaps that is a necessary process for market efficiency. Thus argue supporters of the laissez-faire approach. Regardless, the current state of affairs in the United States is captured by the iconic book Where Are the Customers’ Yachts, which laments the persistent outcome where investment professionals do extremely well, even when their clients do not.
Just as in the United States, China’s regulators observe financial services firms paying its professionals top-tier salaries for delivering bad net-of-fee outcomes to the clients they are supposed to serve. They question why managers should receive huge payouts for poor results? But unlike in the United States, China’s regulators have little faith in their country’s retail-dominated market to find a solution to this problem.
Since the Chinese market can’t be trusted to solve the problem, the proposal currently under debate in China is to regulate compensation in the financial services sector. Specifically, regulators want to link compensation to (dollar-weighted) client outcomes. China has already begun pushing this approach through its state-owned financial institutions. (For those who can read Chinese, here is a short article from Caixin Insights outlining the issue.)
It is much too early to know whether this “compensation innovation” by the financial sector SOEs will resolve the “investor return gap” problem, but one might still want to applaud Beijing for a creative effort. In many ways, pressuring the financial services sector to link compensation to client outcomes is a sensible response to a difficult problem. This is especially true if the market can’t be trusted to solve this problem on its own. However, in the US, this level of interventionist regulation is unthinkable.
It is, of course, easy for the West to interpret this restructuring of compensation for finance professionals as targeting the wealthy and the successful in a move toward anti-capitalism and free markets. But I do not believe that is what is happening.
In my broad personal experience, China’s regulators are not cynical bureaucrats trying to stifle competition or success. I’ve met face-to-face with many of these people. In the financial industry, most are highly educated professionals (many are US- and UK-educated). Without doubt, there is the occasional bad apple, petty politician, or bitter regulator. But for the most part, I’ve found them committed to protecting end-investors and consumers. To top it off, they often face civil or criminal penalties if they are found to have failed at their responsibilities.
Generally, the problems they are trying to address do not touch on ideology or politics. China’s regulators are concerned with the same issues that concern American regulators. These include conflicts of interest, deceptive marketing, false advertising, accounting fraud, personal data misuse and cybersecurity. These issues do not manifest differently in Chinese and US markets; but the severity of the problem is often greater in China.
In the financial services industry, China is still very much the wild West. Regardless of the political system, these are issues that we, as investors, want regulators to care about. As I have pointed out in previous articles, Chinese regulators often pursue these issues with a protective “tiger parent” zeal—an overbearing enthusiasm the West finds uncomfortable. Most western governments prefer to trust the market and laissez-faire economics. (However, they should probably feel less comfortable with that approach in emerging markets.)
At the end of the day, Chinese regulators are civil servants responding primarily to consumer complaints. They are trying to preempt major problems by studying and often copying regulations from the US. The truth is that China’s regulators are not so different from their Western counterparts. By simply recognizing each other as good people wrestling with real challenges in a complex and evolving world, we are more likely to correctly interpret the intent behind Chinese regulatory policies.
For investors who genuinely want to understand China and become better investors, it is useful to review Chinese policies by starting with the problems regulators are trying to solve (and tracking the performance of the policy) rather than the methods they’re using to solve them. Most of us in the West will never be comfortable with China’s tiger parenting approach to regulations. If we focus on the “method”— or the how—we will always be critical and disapproving. If we focus on the “problem”—or the why—then we will find China’s regulators trying to address many of the exact same problems as US regulators.
In this specific example, the conflict of interest between managers and their clients is what leads to poor outcomes for end-investors. That’s a problem we all understand and want to see fixed—both in China and the United States. I have found that when I start with an appreciation of the problem, the regulatory response begins to feel more predictable and a lot less ad hoc and scary. And I also tend to conclude that China is still very much following the Singapore path toward greater economic success.
We may not always be comfortable with China’s regulatory actions. China’s regulators—working in the second largest and fastest-growing economy in the world—make plenty of mistakes in their policy experimentation. But in most instances, those actions reflect well-intentioned people responding sensibly to difficult problems.
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