Things that make you go hmm… Two data points from the HK property market

Kung Hei Fat Choy. The Year of the Dog is almost upon us. With all the preparation ahead of Chinese New Year and the flu season, I have been running around like a chicken with its head cut off (pun intended and reference to the outgoing Year of the Rooster).

How does the math work?

This week, we are just going to keep it brief and share two bits of news on the Hong Kong property market that I find very difficult to reconcile.

Datapoint #1 – Financing for The Center

The first datapoint is from the financing arrangement for the HK$40.2bn purchase of The Center (a Grade A office building in fringe Central).

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According to the Hong Kong Economic Journal, the purchasers are in the process of arranging a US$2.05bn (HK$16bn) three-year loan. In order to boost interest from lenders, the interest rate has been adjusted up from HIBOR plus 140bps to HIBOR plus 160bps. Although one month interbank rates have recently fallen to 0.65%, they were as high as 1.16% as of 2 January 2018. For 2018-to-date, one month HIBOR has averaged 0.91% suggesting that the interest rate for this US$2.05bn loan should be around 2.51%

In addition to the three-year loan, the purchasers are also arranging a one year mezzanine loan of HK$16.5bn at 8.0%.  YES, 8.0%.

Datapoint #2 – Landlord Cuts Retail Rent by 60% for New Tenant

The second datapoint relates to the letting of a storefront in Fringe Central. According to the Hong Kong Economic Journal, a street front store in Lyndhurst Terrace has just been let for HK$85,000/month. The new tenant is a wine shop who has signed a three-year lease. The previous tenant ran a perfume shop and had been paying HK$200,000/month.

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Over the past 3.5 years, the rent has fallen by 57.5%. As the shop was purchased for HK$91.2mn in 2012, the new HK$85,000/month rent works out to a gross yield of 1.1%. Over the past three years, the passing yield has compressed from 2.6% to 1.1%.

How do you reconcile these without using the “Trophy Asset” argument?

When I read these two stories, I just scratch my head on how the math would work here. You’ve got a consortium buying a “Trophy Asset” for HK$40.2bn and seemingly financing 81% of the price with short-term money (one and three-year loans). With interest rates going up and Central banks winding down QE and starting to reduce their balance sheet, it seems likely that financing costs would only go up when the loans rollover.

Secondly, as the retail shop example show, rents do not always go up. For the shop owner who had bought in 2012 hoping that the 2.6% entry-yield could be improved with rental increases, rather than rising, the entry yield has more than halved to 1.1%. Unless it was an all-cash purchase, otherwise, it must be a negative carry now.

Now, I know the die-hard bulls would argue that the price has gone up and hence the capital gains have more than offset the rental decline. But if current yields are only 1.1% and the latest lease has shown that the fairy tale of ever rising rents is clearly broken, what would entice the next Greater Fool to up the next bid?

As the tide of easy money start to recede, we will soon find out who’s been swimming without their swimming trunks on.

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Mass Consumption 10 – Sweet Tooth

For those with a sweet tooth, the upcoming Chinese New Year holiday will test your will power. In case you’re not familiar with Chinese New Year tradition, families usual keep a box of sweets at home. When friends and families come over to visit during Chinese New Year, they’re supposed to have some sweets so that they will  have a sweet year ahead.

Traditional Lunar New Year Candy Box

To give you a feel, here’s what we are stocking at home. You can see some traditional local candies like the “White Rabbit”, “Yan Chim Kee Coconut Candy”, the “Orange/Melon Jelly Candy”, as well as some western favourites like Dairy Milk and Crunchie.

Who Made Dairy Milk? Cadbury, Hershey, Kraft or Mondelez

Two of my favourite chocolate bars are the Dairy Milk Fruit & Nut and the Crunchie. While Crunchie taste pretty much the same around the world, Dairy Milk has been a source of contention. Some argue that UK version is far superior to what you can buy in the US or elsewhere.

This brings us back to the above question.

Who makes Dairy Milk? The answer is “All of the above”.

I couldn’t get my hands on an American version. Top bar Made in the UK, Bottom bar made in Australia

Officially Dairy Milk is made by Cadbury. However, in the US, Hershey has the license to manufacture and distribute Cadbury products. In the rest of the world, it would be made by Cadbury UK.

However, Cadbury UK was bought by Kraft Foods in February 2010, so one could also argue that Dairy Milk is made by Kraft. But hang on, there’s more. The Kraft Foods from 2010 is not the same as the Kraft Heinz today. In October 2012, Kraft Foods decided to spin off its North American grocery business, calling it Kraft Foods Group Inc. The original entity, Kraft Foods, was renamed as Mondelez (MDLZ). Then in 2016, Kraft Foods was merged with Heinz to form Kraft Heinz Company (KHC).

Why the long intro? That’s the most exciting part

I was first drawn to Kraft Heinz when I saw its share price chart for 2017. Against the S&P 500’s 19% gain, KHZ had fallen by 11%. MDLZ did not do much better, falling some 3% in 2017. Normally, this is the type of set up that I find interesting. Household brands that had lagged behind the broader market and potentially poised for a catch up.

However, the first thing that cooled my interest was their PE. Even with the past week’s market correction, KHC and MDLZ were both still trading at 23x. Intuitively, I tend to think of 20x PE as fair for consumer staples. While I see KHC and MDLZ as having great products, current valuation seems to already reflect that.

But is there another angle? If you cannot count on multiple expansion, what about earnings growth. Are people eating more chocolates? Buying more ketchup? What about growth from the emerging markets? Are the Chinese splashing more ketchup onto their KFC fried chicken?

Geographic spread – KHC very North America centric, Mondelez more evenly split

We start by looking at their sales distribution. Here we see quite a big difference between the previous sister companies. KHC is predominately a US and North American focused company. The US and Canada account for 70.4% and 8.7% of its sales. Europe and the Rest of the World are only 8.9% and 12.0% of KHC’s sales. I guess that’s why it had looked to Unilever to add some geographic diversification to its business.

Mondelez, on the other hand, has sales that is more evenly distributed. Europe is the biggest contributor at 37.8% of sales, followed by North America at 26.2%. AMEA (Asia Middle East and Africa) is the third biggest at 22.2% with Latin America rounding things off at 13,8%. As Cadbury is licensed to Hershey in the US, this probably explains why Mondelez’s North America business trails its European side.

Products Mix

I know I have been talking a lot about Cadbury chocolates but there are actually a lot more to MDLZ. Some of its other brands include Oreo, Nabisco, Toblerone (another one of my favourites), Trident chewing gum, Halls and Tang. The three biggest sales categories are Biscuits at 41% of sales, followed by Chocolate at 30% and Gum and Candy at 15%. The reason why these seem to be increasing in proportion is due to Mondelez injecting its coffee business into what eventually became Keurig.

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For Kraft Heinz, as the name implies, condiment & sauces and Cheese & dairy are the biggest contributors at 26% and 21%. But in case you’re wondering, its brands also includes the likes of Oscar Mayer, Planters, Maxwell House, Philadelphia, Kool-Aid and Jell-O just to name a few.

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Sweating costs rather than top line growth

With so much acquisitions and divestments over the years, it is difficult to compare sales trends. However, if we just look at the last reported year, we see that Mondelez overall sales was flat. LatAm was the fastest growing region at 5.1%. Europe gained 0.4% but AMEA and North America both saw overall sales declining by 1.3% and 2.3%.

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For KHC, during the first nine months of 2017, its overall sales declined by 1.4%. Sales in the Rest of the World grew 5.1% but the other three regions all declined. The US and Europe declined by 1.7% and 1.6% while sales in Canada tumbled 5.5%.

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I don’t know whether it is just consumer staples or the fact that people are making healthier choices but the inability to grow the top line is something that we also saw in China’s instant noodle market as well (see previous post here).

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The good news is that although it has been difficult to find top line growth, both companies have been effective in cutting costs and boosting margins. For MDLZ, over the past four years, it has managed to boost its operating margin from 11.3% to 15.0%. Through the first nine months of 2017, KHC’s operating margin was 26.5%, up 11.5pp from 2014’s pro-forma 15.1%.

Think I’ll wait for them to go on sale

While I like the margin improvement story, with fair valuation and little top line growth, my compulsion to act is low.

That said, with the recent volatility in the markets, I suspect these two great products may well be on sale soon.I just hope that it won’t be a 2-for-1 sale. If that is the case, I will need to eat a lot of chocolates to help cheer me up.

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Small Moment – Has the high yield market hit an inflection point?

When the facts change, I change my mind. What do you do, sir? – John Maynard Keynes

When I was growing up, English lessons in my country were mostly focused on grammar. We learnt how to conjugate verbs, what punctuations to use but we never learnt about the different writing styles. I never knew there was such a thing as persuasive writing, narrative writing or writing about small moments. It wasn’t until my kids started primary school that I learnt that small moment writing is when you zoom in and focus on an object/event.

What does one company’s borrowings tell us?

For this post, we are zooming in and focusing on one company’s borrowing history to see what it can tell us about the high yield bond market.

The first chart below shows us the USD denominated bonds that this company had issued since 2013. With the exception of the August 2017 and December 2017 bonds, the other bonds were generally 4-5 years in duration.

Small moment 1 – Uptick in borrowing costs?


The first thing that struck me was how much the coupons had fallen. Five years ago, a 5-year bond would have carried a coupon around 12.25%. This has now fallen to 5.5%.

The second notable is the uptick on the far right hand side. For this company, while the latest 5-Yr bond carried a 5.5% coupon like the one that it issued 12 months ago (January 2017), its cost of borrowing has actually ticked slightly higher. Counting a lower offer price, the effective yield was 5.625%. Furthermore, although the 2017 perpetual bonds have an interest rate reset mechanism, their coupon of 5.375% is actually lower than the 5 year notes. To me, this feels like the costs of debt have reached an inflection point.

Small moment 2 – Loosening of covenants?

The second small moment that we are zooming in on are the club loans. Over the past three years, there have been four club loan arrangements. Like the above corporate bond picture, we see that interest rate spreads have compressed. Back in January 2015, the interest rate spread on a US$120mn club loan was set at 4.75% above interbank rates. This fell to 4.0% in 2016, 3.75% in January 2017 and then to 3.3% in September 2017.

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Unlike the bond picture above, the interest rate spreads on club loans have yet to inflect. But what was interesting was the loosening of borrowing covenants. While the first three club loans all require the company to keep net borrowing to tangible net worth below 85% and EBITDA-to-interest above 3.0x, the latest loan loosened the covenant to 95% and 2.75x. As Central banks now start to normalise their balance sheet and global liquidity start to recede, it would be interesting to see if future club loans see a higher interest rate spread and/or stronger covenants.

Small moment 3 – Increased borrowing frequency

Our third and last small moment is the borrowing frequency. Since the start of 2017, this company has issued four bonds and arranged two club loans.

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Unlike previous years, when borrowing were arranged every 6-12 months, the past four bonds were issued on January, August, December and January. Either investors’ bond appetite is still very strong or you’ve got a very smart CFO that is locking in cheap money while he can.

Collectively, these three small moments are suggesting to me that there is a smarter person on the other side of this trade. I think I’ll let this pitch pass. After all, we’re not writing about baseball here.

Mass Consumption 9 – Battle of the Robotic Surgeons

Do you remember the movie “Big Hero 6”? Can you believe it came out nearly four years ago?

It was a pretty good movie but what really stood out to me was its idea of a robot. You see, I grew up with the likes of Transformers and Gundam, so for its Hero to be a soft and cuddly robotic “Michelin Man”, this was something new. But not to be overlooked were the tiny microbots that Hiro created.

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During the robotics competition, people initial laughed at the microbots but once they realise what the small nimble robots could do, it proved to be a game changer.

Source: Big Hero 6 Wiki

Well, in the real world of robotics-assisted surgical systems, how would a small player stack up against a competitor that is 75x its size? What are the similarities and differences when one generates US$2.7bn of sales and another just US$36mn?

Big Guy Versus the Little Guy

In our previous post Mass Consumption Part 5 – The Six Million Dollar Man, we examined the medical equipment market. In that post, Intuitive Surgical (ISRG) played the role of the small and nimble up and comer while the big incumbents were the likes of Medtronics and Stryker.

In this post, when when we compare ISRG against another maker of robotics-assisted surgical systems, Mazor Robotics (MZOR), ISRG is now the big giant. In terms of revenue, ISRG’s US$2.7bn in 2016 was 75x larger than MZOR’s US$36mn.


System Sales versus Recurrent Income

When we initially reviewed ISRG back in August, one aspect that caught our eye was its large recurrent income base from the sale of (i) instruments and accessories and (ii) service and maintenance fees. Together, these two revenue items made up 71% of ISRG’s overall sales and provided a good source of recurrent income.

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For MZOR, given its smaller base, system sales still make up more than 50% of its sales. The recurrent incomes of supplies and disposable plus service and maintenance make up a smaller 46% of sales. However, as system sales continue to rise, we could see MZOR’s recurrent income base starting to rise in the future.

US market remains the key sales driver

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For both players, the US is by far the most important market. For ISRG, the US make up 73% of overall sales. For MZOR, it is even bigger at 84%. So even as MZOR grows and diversifies into other international markets, it is probable that the US would remain the key to its future success.

SG&A is the key to profitability

Although ISRG’s sales is 75x larger than MZOR’s, the two companies actually have fairly similar gross margins. As the following chart shows, in the latest 9M 2017 results, ISRG and MZOR’s gross margins were both around 70%.

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Another area that has started to converge is Research and Development. In 9M 2017, R&D expenses was 12.4% of MZOR’s sales. For ISRG, it was 10.8%. But of course, if one were to look at this in absolute terms, ISRG spent US$242mn versus MZOR’s US$5.7mn.

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While ISRG and MZOR’s gross margin and R&D expenses are similar, the biggest difference and the key to profitability was actually Sales and Marketing.

For ISRG, SG&A ate up 26.5% of sales. But for MZOR, it was a whopping 82.5%. On a net basis, this results in ISRG having a net margin of 31% while MZOR’s net margin remains negative at -26%.

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The importance of sales and marketing has been a consistent theme. Even for the medical giants like Medtronic and Stryker, SG&A expenses were the biggest cost item, accounting for some 30%+ of sales.

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Organically driven growth so far…

Unlike the big medical behemoths like Medtronics and Stryker where M&A plays a key role in driving growth, ISRG and MZOR are more organically driven. Goodwill only make up 3.6% and 1.6% of ISRG and MZOR’s asset base. By comparison, for Medtronics and Stryker, in December 2016, goodwill accounted for 39% and 31% of its total assets.

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Microbots + Death Star

Given the importance of sales and marketing to growth and profitability, how does the tiny microbot catch up? One way would be to continue to pour money into sales and marketing staff and hope that sales growth offset increased expenses. Another way would be through M&A (that’s why there are such large goodwill balances on the books of the big medical giants). A third way is through strategic alliances.

Mazor chose option 3 and entered into a strategic partnership with Medtronics. In addition to investing US$72mn in Mazor (potentially up to US$125mn counting conversion of warrants), the partnership also sees Medtronic assuming worldwide distribution for Mazor X system. As Medtronic generates annual sales of US$30bn, this would be like the microbots being backed up by the Death Star.

Logically, this makes a lot of sense. I just hope they didn’t do the silly Star Wars thing and leave a critical 2 metre exhaust port for the rebel forces to hit.




TGIF: Lessons from the “Salty Kumquat”

What do you think of when you hear “Chinese New Year” and “Flu Season”?


If you grew up in Hong Kong, you might be thinking about of 鹹金橘 or “Salty Kumquat”. This traditional home remedy does wonders for sore throats and colds. As for the reasons why, it’s simple.

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First, the Kumquat is a citrus fruit, hence it should contain Vitamin C like oranges and lemons.

Second, as the kumquat is preserved in salt, the high sodium content acts as an antiseptic.

Like a fine wine, you can’t rush a fine kumquat

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Although it would just be like your doctor giving you Vitamin C and asking you to gargle with salt water, I think the “salty kumquat” just seems to work better.

But there’s a catch. You won’t find “Salty kumquats” in your neighbourhood grocery store. You see, the “salty kumquat” needs to go through an ageing process and many would agree that the older the salty kumquats become, the better and more effective they are.

So every year, after Chinese New Year has passed, families would pluck the kumquat off their potted plant and salt them. And just like a fine wine, you can’t rush the process.

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Salty Kumquat after ONE YEAR

And then after another 1,095 days….

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Salty kumquat after FOUR YEARS

Till eventually, it becomes something like this.

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Salty kumquat after 20+ YEARS

At this point, it is so precious that you don’t even want to consume it.

Just be Patient and Trust the Process

So how does the “Salty Kumquat” connect to all the other posts?

It’s just a reminder to be patient and trust the process. Like the salty kumquat, investments also need time to play out. There could be long period where nothing seems to be happening. If you check on your salty kumquat everyday then good luck. Don’t poke it, don’t shake, instead just give it time and trust the process.

But before we conclude, the salty kumquat holds one more lesson. Be meticulous with your preparation. The first time that we tried to make it, our batch turned mouldy and had to be thrown out. Just like doing proper research on an investment idea, you’ve got to prepare the kumquat meticulously. We flash boiled, wiped them then air-dried for a few days. And in this initial stage, you do want to check on it regularly to make sure that the salt is covering the kumquat. But once that is done, just sit back and relax cause worrying won’t make the process go any faster.

Here’s to good health and a flu-free Year of the Dog!


TGIF: Hmmn, I never knew that – Squats

It’s been a while since we  have done a funny Friday piece.

I used to see lots of silly stuff like the “facial scan for toilet paper” and the “umbrella sharing scheme”. Well, this one is not along the lines of ludicrous ideas but more of the “hmmn, I never knew that” variety.

But first a health warning. I will be talking about toilets and if you are reading this during meal-time, you may want to put down your device and come back later. If you’re ready to “squat” in, scroll past the calming pictures below.

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When you hear the words “squatting” or “squats”, what do you think of?

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For the health nuts, you probably think of the exercise designed to strengthen your thighs, hips, buttocks and your core.

For those obsessed with real estate and finance, they are probably thinking of the illegal occupation of real estate.

But for those who travel to China, one of the most dreaded sights must be that of the squat toilet. Here is a picture of one.

Source: China Highlights

Most of the time, when you see one of these things, the first and likely only thought on your mind is “How do I get out of here as quickly as possible?”

Forwards or backwards?

But for those who have a naturally curious mind, have you ever wondered which direction you’re supposed to face?

This is especially the case when you see one of those squat toilets that have a hood on it like the one shown below.

Source: Wikipedia

What is the hood for? Are you suppose to aim at it? What about splash back?

Well, I got all my questions answered earlier this week and it came from the most unlikely of sources, the Hong Kong Economic Journal. For those unfamiliar with the name, this is Hong Kong’s version of the Wall Street Journal. It’s generally full of good analysis, thoughtful opinions and in this instance great trivial facts.

According to this article, the origin of the squat toilet hood can be traced back to the traditional Japanese outfit. In the old days, people used to dress in the traditional yukatas/kimonos. The hood was meant to prevent the back of the yukata from falling into the squat toilet (see the bottom left of the below picture).

Source: HK Economic Journal

So there you have it. Face forward. Now, get out of there as quickly as you can and Happy Friday!

Your Money’s Worth? MPF Fees

On 3 January 2018, MiFID II came into effect. For many, this was supposed to spell the death of sell-side research. In our previous post MiFID II – What would you pay for content?, we found that in the world of online literature only 6% of readers pay for content and the average pay rate was only Rmb20 per month. The silver lining from those figures was that both are rising. This suggests that if the content is good, there is money to be made but you need massive volumes.

In this post, we take a look at the other side of the coin. Fees charged by the Buy-side.

Average Fees for 556 MPF Schemes – 1.56%

According to data from Hong Kong’s Mandatory Provident Scheme Authority, the average fee (i.e. Fund Expense Ratio or FER) for the 556 MPF funds that it list is 1.56%. Money market funds have the lowest fee ratio at 0.60% (for MPF Conservative) and 0.95% (for MPF Non-Conservative). This is likely due to the very low returns that money market funds get in today’s low-interest environment. If they were to try to charge higher fees, annual returns would probably be negative.

At the other end of the spectrum, fees for Guaranteed Funds are the highest with average FER of 2.06%. The most popular products are those with an equity component. Mixed asset funds and equity funds make up 45% and 33% of the 556 total MPF funds. These have the second and third highest FER ratios at 1.72% and 1.55%

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Average fees reduced by 24.27% since 2007

Although the MPF Authority’s Fee Comparison website proudly state that average FER has been reduced by 24.27% since the site was launched in 2007, I don’t want to jump to the conclusion that lower fees are better, although this is generally true.

For now, let’s leave the possibility that some of these funds are charging higher fees so that they can invest in more research/systems and drive better returns. After all, if revenues (investment gains) are rising faster than costs (fees) then we are all better off, right?

What would you pay just to track the index?

While we can apply the above argument to many actively managed funds, it should not apply to passive funds. For those unfamiliar with the term, Morningstar defines passively managed fund as a “fund whose investment securities are not chosen by a portfolio manager, but instead are automatically selected to match an index or part of the market.”

Since passive funds are designed to match or track an index, higher fees are just higher fees. Theoretically, the higher fees should not lead to any outperformance. In fact, this would be considered a tracking error.

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FERs are way too high still at 0.71-1.14%

When we reviewed the data from the MPFA for several funds that track Hong Kong’s Hang Seng Index, we found that their Fund Expense Ratios ranged from 0.71% to 1.14%. At first glance, these may seem reasonable when you compare it to the 1.55% average fees charged by the equity funds but remember these are passive products that are just supposed to track and not outperform an index.

Tracker Fund Charge Ratio is Only 0.1%

If these are compared to a the Tracker Fund of Hong Kong, we see how unreasonably high those fees are. The Tracker Fund of Hong Kong currently has net asset value around HK$102bn. It tracks the performance of the Hang Seng Index and has an ongoing charge ratio of 0.1%.

Yup, that is 0.1% compared to the 0.71%-1.14% above.

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Yes, some of this may be down to base effect (0.1% of HK$102bn is still HK$102mn) but for some funds that are essentially just ploughing 99% of the money received to the Tracker Fund, what is the value add from an annual 1% admin fee?

I guess paper and ink to print annual fund statements must be pretty expensive. Come to think of it, Hong Kong’s largest listed paper manufacturing company did rise 64% last year. Hmmm…

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Source: Google Finance