(Sept 18): If you are a fund manager, you probably wish there was a place you could go where the passive investing craze never caught on, and clients still shelled out handsomely for stock picking. That place is Hong Kong.

Hong Kong, where passive investments are little more than sidekicks, amassing the equivalent of 5% of active funds. Hong Kong, where customers are loyal to active managers, even though they do no better here than anywhere else, with about three-quarters of such funds losing to benchmarks.

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How this happened is a lesson in the power local banks can still wield in cultivating investor appetites. While the immaturity of the exchange-traded fund (ETF) market has stunted its growth in Hong Kong, just as big a barrier has been a system of incentives, where banks are paid by fund companies to push active managers.

“Bank staff aren’t selling funds based on how good a fund is, but because of commissions,” says Ricky Tam, chairman of the Hong Kong Institute of Investors. “Investment in mutual funds is very much influenced by sales tactics such as promotion and advertising, but ETFs don’t do that because their selling point is their low cost.”

The result is an anomaly among major investing centres. While the US, Japan and Europe have seen waves of money flowing into ETFs over the past year, in Hong Kong it is the other way around. Almost US$900 billion ($1.21 trillion) sit in active strategies, Morningstar data shows, but only about US$41 billion have made it to ETFs — and that is down 8.3% this year, according to data compiled by Bloomberg.

Slowly, steps are being taken that may change things. Regulators are looking at enhancing commission disclosure, while pensions are adding lower-cost passive options. Vanguard Group, the world’s second-biggest money manager and a champion of passive funds, has upped its presence in Hong Kong and is offering five ETFs in the city.

While it is a long way from the transparency being promoted by new European rules governing stock research, Hong Kong’s Securities and Futures Commission (SFC) has proposed regulating incentives of independent advisers and enhancing the disclosure of benefits received by fund distributors, including trailer fees.

Both Vanguard and the Hong Kong Investment Funds Association support the proposals. The SFC declined to comment as consultations are ongoing. The regulator has, in a paper, cited data showing that local investors do not have the appetite to pay fees for advice.

“At the end of the day, investors want to achieve the best chance for investment success, which is the net return they are receiving in their pocket,” says Yan Pu, head of portfolio review at Vanguard in Hong Kong. “As far as they have the full transparency of what they’re paying for, they will be able to make a rational decision.”

The US has seen a seismic shift from active to passive investment since the global financial crisis. ETFs and index funds equalled 47% of active funds in terms of total net assets at end-2016, up from 27% in 2011, Investment Company Institute data shows.

Active managers swear they have an edge in Asia. Inefficiencies in emerging Asian markets allow more room for alpha, says Eric Moffett, a fund manager at T Rowe Price Group in Hong Kong. Morningstar’s fund ratings show active funds in emerging markets have a bigger advantage over ETFs than their peers in developed markets, says Jackie Choy, director of ETF research at the fund consultancy in Hong Kong.

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Still, among the 561 active funds in Hong Kong whose benchmarks are available in Bloomberg-compiled data, 23% outperformed their gauges over the past three years by more than 1.5 percentage points — a typical expense ratio for local funds. Among the 177 active stock funds that invest in Asia-Pacific, 28% pulled that off.

To Vanguard’s Pu, the ETF market has been hindered by the distribution model and low liquidity. Among local ETFs, 91% have an average 30-day volume of less than a million shares, compared with just 8% of Hang Seng Composite Index constituents. Pu says one solution is letting Chinese investors buy Hong Kong ETFs as part of an existing link between the city’s and mainland’s markets —something the Hong Kong exchange is studying.

In a boost to index funds, Hong Kong’s government launched its Default Investment Strategy pension programme this year to offer diversified and low-cost investments. Both BlackRock and Vanguard have debuted funds under this category.

“The shift towards passive investment will happen, but we just need a catalyst,” says Au King Lun, CEO of Value Partners Group, a 24-yearold local asset manager overseeing about US$16 billion. “What SFC is doing now — making commissions more transparent — could be one, but it may take a while before people change their behaviour.” — Bloomberg LP

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