The Benefits of Default The Possible Default of a Trust Product in China Should Be a Wake-Up Call for Investors

The Benefits of Default

The Possible Default of a Trust Product in China Should Be a Wake-Up Call for Investors

WEI GU

Jan. 23, 2014 11:49 a.m. ET

Wealth management is booming in China, but some of the products being sold can be risky. Soul Htite, the CEO of Sino Lending, tells WSJs Wei Gu what investors need to be aware of when buying investment products.

The possible default of a trust product in China should be a wake-up call for investors, many of whom believe the government will stand behind anything they buy from banks.

High-yielding investment products have exploded in popularity in the past few years as investors flee low-return bank deposits. And while there will likely be more trouble with such products, they can be good for savers if people invest with care.

So far, Chinese investors who bought fixed-income wealth-management products have enjoyed higher returns than bank deposits offer, without suffering any losses. But that looks to be changing now, as a slowing economy starts to expose the weakness in the system, and the Chinese government may not want to absorb all the losses.

Investors need to adjust by not treating trust products as all the same, instead focusing on finding well-run offerings that fit their risk appetite and investment goals and that diversify their portfolios.

For now, the focus is on a three billion yuan ($500 million) fixed-income wealth-management product sold by the Industrial & Commercial Bank of China,601398.SH 0.00% issued by China Credit Trust and backed by loans to a struggling coal miner, Zhenfu Energy Group. As the maturity date of Jan. 31 nears, worries that the company can’t pay back the loans are growing—and investors are calling on ICBC to cover their losses.

The money at risk is a drop in the bucket for China’s trust industry, whose total assets at the end of the third quarter exceeded 10 trillion yuan ($1.67 trillion)—up 60% from a year earlier— largely because there is lots of cash chasing too few good opportunities. Chinese investors don’t trust the stock market. Bank deposit rates, kept artificially low, generally lag behind inflation. The government has made it harder and more expensive to buy real estate.

The first lesson investors should take from the potential default is that earning a low return is better than losing money. Laura Zhang, a Shanghai housewife, invested two million yuan in an investment product from New York-listed Noah Holdings Ltd., managed by Guangfa Securities, in 2011.

She was told the money would be used to buy large blocks of shares on the stock market that would then be sold to small investors at a profit. But the fund changed strategy after a few months, shifting from block trades to private placements—allowed under the contract, though they weren’t supposed to be the focus. Instead of delivering an annualized return of 60% as originally projected, it lost 12%.

Noah said it doesn’t guarantee the principal of investment products like the one bought by Ms. Zhang, and adds that its fixed-income products have never lost money.

Ms. Zhang, who is married to a lawyer, regrets not carefully reading the fine print of the documents she signed. “All those big institutional names associated with the product made it look quite safe, but when it failed to deliver, no one is assuming any responsibility,” she said. Now, she mostly invests in start-ups and private-equity firms run by people she trusts and has known for more than five years.

“The moment you think that you can just be lazy and outsource the decision to someone else, there will be a problem,” said Ms. Zhang. “It is your money after all, and you have to take full responsibility.”

Ms. Zhang invests funds she’ll need in the short term in conservative reverse-repurchase agreements issued by the People’s Bank of China, which currently yield about 6%. (The good news for investors from China’s continuing cash crunch is that low-risk money-market investments are offering quite healthy yields, providing a reasonable place to park money they know they will need in the next few years—say, to pay for college.)

Investors looking to beat the yield offered by bank deposits should make sure they understand what happens if an investment goes bad. The potential of a big loss should be balanced by enough of a potential return to justify the risk.

They should also consider whether the investment diversifies their holdings, a classic way to reduce risk. People who already own multiple apartments, for example, might do best by avoiding funds that invest in real estate.

Finally, they should look at how the fund is run. Some banks charge commissions as high as 4%. Some products are vague about investment strategy and leave themselves a lot of freedom to change it.

It is no surprise that Alibaba Group’s Yuebao fund has become China’s biggest mutual fund in just six months. By leveraging their gigantic customer bases and taking advantage of low-cost Internet infrastructure, new entrants such as Alibaba and Tencent HoldingsTCEHY -5.11% are able to charge lower fees. And they offer better disclosure than many of their competitors.