Are China A-shares an opportunity for investors?
With recent efforts from the government to open up the China A-share market to foreign investors and its addition to the MSCI Emerging Markets Index in May 2018, we are undeniably on the cusp of a new dawn for China equities. This piece contends that the risks related to the nature of the market and the investor base should not be overlooked, but instead exploited, as they can potentially lead to volatility and mispricing. Man Numeric argues that in this context, active managers may find particular opportunities in China A-Shares.
With recent efforts from the government to open up the China A-Share market to foreign investors and its upcoming addition to the MSCI Emerging Markets Index in May 2018, we believe we are undeniably on the cusp of a new dawn for China equities. After 25 years of dramatic growth, we believe the market now represents a potentially compelling investment opportunity for foreign investors looking to diversify their portfolio, both from alpha and beta perspectives. Due to capital controls and a market structure limiting arbitrage opportunities, China A-Shares might be the last major equity market to offer a real source of beta diversification for the foreseeable future. Risks related to the nature of the market and its investor base should not be overlooked, but sought to be exploited as they could lead to volatility and mispricing that may result in an attractive opportunity to generate alpha. In this paper, we explore some of the key risks and opportunities presented by this market, arguing that it may offer fertile hunting ground for active managers in the coming years.
Historically inaccessible to foreigners, China A-Shares trade in renminbi (RMB) on two Chinese exchanges: the Shenzhen Stock Exchange and the Shanghai Stock Exchange. Before 2003, foreign investors who wanted to access Chinese markets were restricted to a limited subset of mainland companies trading on the Hong Kong Stock Exchange and denominated in Hong Kong dollars, known as China H-Shares. In 2003, China A-Shares first became available to foreign investors through the Qualified Foreign Institution Investor (QFII) program. Initially very restrictive in terms of investment quota, lock-up period, and capital repatriation, QFII rules were finally relaxed by China’s State Administration of Foreign Exchange’s (SAFE) in February 2016, making it less restrictive for foreign investors to participate. In late 2014, foreign investment in China A-Shares took a dramatic shift with the launch of the Shanghai-Hong Kong Stock Connect, allowing international investors to purchase A-Shares traded on the Shanghai Stock Exchange through Hong Kong-based brokers. In December 2016, a similar program was launched to allow foreign investors access to the Shenzhen Stock Exchange. The introduction of the Connect program was a significant milestone on the way to MSCI Index inclusion.
Investment universe – large, liquid and diversified
China’s equity market has been growing at a dramatic pace since its opening in 1991 (Figure 1), both in terms of market capitalization and breadth of listed companies. After only 25 years of existence, it is currently the second largest and most liquid equity market in the world, following the United States (Figure 2).
Figure 1. Growth of the Shanghai and Shenzhen stock exchanges
Source: SSE, SZSE, Bloomberg.
Figure 2. Top five markets by capitalization and liquidity as of Dec. 30, 2016
Source: Man Numeric, Bloomberg.
To think about this market from an investor’s perspective, we define our investible universe (Man Numeric China A-Share universe) as the combination of the Shanghai Shenzhen CSI 300 Index and MSCI China A IMI Index. It is composed of 2,098 securities (as of December 30, 2016) and represents about 99% of the total float-adjusted market capitalization.
Reflecting the dramatic growth of the China market, the number of securities in the Man Numeric China A-Share universe has nearly doubled over the last seven years, from 1,191 in January 2010 to 2,098 at the end of 2016. The universe covers the full capitalization spectrum, with the smallest percentile below USD 500m and the top percentile above USD 35bn as of December 30, 2016, while the median stock has a USD 1.3bn market capitalization. We believe one of the attractions of China’s market for investors is the high liquidity of its stocks. While the median stock has an average daily liquidity of USD 15m (calculated over a 3-month period), 99% of the universe trades more than USD 1m a day and up to USD 600m for the most liquid stock, providing ample liquidity for active investors.
Figure 3. Sector breakdown of the MSCI China A IMI Index as of Dec. 30, 2016
The sector distribution of the China market is fairly diversified and less concentrated than the broader Emerging Markets. Its top three sectors only represent roughly 50% of the total market capitalization (Figure 3) versus 60% for the MSCI Emerging Markets Index. Industrials is the largest sector, while the Information Technology sector represents less than 10% of the total market capitalization (compared to almost 25% for Emerging Markets) as several large companies are only listed in Hong Kong or the US. One exception to the diversified nature of the China market is the Financials sector, the second largest sector by market capitalization, which is highly concentrated as it only represents 3% of the total universe breadth.
Potential risks and challenges
Retail investor base has grown – and so has pricing inefficiency
The last few years have witnessed a surge of new retail investment in China A-Shares. The amount of combined retail investment multiplied 7-fold over the last decade, from just RMB 6 trillion in 2006 to just over RMB 43 trillion at the end of 2016 (Figure 4).
According to the results of a December 2014 survey of Chinese retail investors, 62% of investors surveyed had less than the equivalent of a high school education. (Source: Bloomberg, Southwestern University of Finance and Economics). The survey results lead us to believe that most Chinese retail investors may be making investment decisions based on speculation and faith in the Chinese government, reflective of a lottery-type approach, rather than a more traditional investment valuation principle. Supporting this hypothesis, Ng and Wu (Revealed Stock Preferences of Individual Investors: Evidence from Chinese Equity Markets, 2006) studied investment patterns of retail investors. The authors show that, while wealthy retail investors tend to rely on traditional investment principles (book-to-price and momentum), less wealthy retail investors favor high-beta, low price, low earnings and underperforming stocks. And with limited access to offshore investments and attractive yields on credit products, the equity and real estate markets are often the only release valve for retail investors. The risks associated with this lottery-effect irrationality are real and can potentially lead to heightened volatility, as witnessed in the summer of 2015. However, this behavior has the potential to create significant mispricing in the market and be exploited by skilled active managers seeking to generate alpha.
Figure 4. Combined China A-share market capitalization (Jan. 1998 – Dec. 2016)
Market valuation risks as policy relaxes
Another consequence of the historically limited access to offshore investments is the risk of overvaluation of the China A-Share market. Reinforced by the prohibitive cost and limited availability of shorting in the A-Share market, arbitrage opportunities have been virtually non-existent, leading to divergence in the valuations of the A- and H-Share markets. As of December 2016, the valuation of the MSCI China A-Share Index was roughly double the valuation of the MSCI China H-Share Index (Figure 5).
Figure 5. Valuation metrics (as of Dec. 30, 2016)
|MSCI China A-Share Index||MSCI China H-Share Index|
|Price / Earnings||19.1||7.7|
|Price / Book||2.0||0.9|
|Price / Sales||1.5||0.9|
As the government relaxes capital controls and allows more foreign investments in the local equity market through the Stock Connect programs, arbitrage opportunities could arise and push valuations towards convergence.
State-owned enterprises – Promises of reform, but real transformation is a ways off
State-owned enterprises (SOE) are corporations fully or partially owned by the central or a regional government. While SOEs pursue a commercial interest, they may also have a public policy objective, particularly in strategic areas where the government traditionally wants more oversight, such as the banking, defense, electricity, or oil industries (Figure 6).
Figure 6. Capitalization-weighted percentage of government ownership by sector (Man Numeric China-A universe as of Dec. 2016)
Source: Man Numeric, Bloomberg.
Across the Man Numeric China A-Share universe, SOEs tend to be large but relatively illiquid companies due to their limited float (Figure 7). With executives appointed by the Communist Party of China (CPC), incentives are largely misaligned with firm performance and SOEs have often been crippled by inefficiencies, leverage, and over-capacity. On average less profitable than privately-managed companies, SOEs have historically underperformed.
Figure 7. Historical average exposure to Barra Risk Factors (spread between top and bottom quartiles of state ownership. Jan. 2010 – Dec. 2016)
Source: Man Numeric, MSCI Barra.
While the government has promised reform to make SOEs more competitive, mainly through mergers and consolidation, improvements have been slow at best, indicating to us that a successful transformation will be challenging. Keeping SOEs’ risk profile in mind, we believe it seems therefore suboptimal to consider naïve cap-weighted passive investments as the vehicle of choice. Active management would allow deviating from the benchmark while sophisticated model development would aim to reduce any unattractive SOE exposure.
Opportunity for active managers?
Correlation with other markets is relatively low
From a purely passive standpoint, the China A-Share market would have been a positive contributor to any investment portfolio. The MSCI China A-Share Index returned almost 400% since 2005, roughly 4 times the return of the MSCI Emerging Markets or MSCI World Indices (Figure 8). However, this performance came at the price of higher volatility as the period covered two massive rallies followed by almost as severe sell-offs (Figure 9).
Figure 8. Cumulative total return
Figure 9. Annualized total return and volatility (Jan. 2005 – Dec. 2016)
|Annualized total return||Volatility|
|MSCI China A-Share Index||13.9%||9.4%|
|MSCI Emerging Markets Index||6.5%||6.6%|
|MSCI World Index||5.6%||4.4%|
That said, this market provides significant diversification from both developed and emerging markets, more so than the China
H-Share market, due to its limited access for foreign investors. In spite of an increase in correlation in recent years and a short episode of elevated correlations during the post-Global Financial Crisis rally (Figure 10), the average correlation of the MSCI China A-Share Index with the MSCI Emerging Markets Index and the MSCI World Index since 2005 has stayed below 0.3 and 0.2, respectively. For investors with exposure to China only through the H-Share market, the A-Share market represents a real diversification opportunity as the average correlation between the two markets is only 0.5 (Figure 11).
Figure 10. Rolling 12-month correlation of weekly USD returns
Source: Man Numeric, Bloomberg.
Figure 11. Average correlation of weekly USD returns (Jan. 2005 – Dec. 2016)
|MSCI China H-Share Index||MSCI EM Index||MSCI World Index|
|MSCI China A-Share Index||0.50||0.28||0.17|
|MSCI China H-Share Index||0.82||0.63|
|MSCI EM Index||0.85|
Source: Man Numeric, Bloomberg.
Cross-sectional variance of returns points to potential opportunities for active managers
Decomposing the cross-sectional variance of returns between different sources (sector, Barra risk factors, and stock specific) highlights the magnitude of the potential opportunity set for an active manager (Figure 12). The China A-Share market exhibits some interesting characteristics. First, sector returns have a fairly limited impact on explaining the variance of returns. In other words, picking the right sectors would do little to help a manager outperform the market. Second, the contribution of the various styles (Barra risk factors) is significant and dominated by the contribution of Size and Volatility, which we believe underlines the need for a risk-controlled approach in this market. Finally, the main contribution to the variance of returns remains stock specific, i.e., not explained by sector or style returns, creating a significant set of potential opportunity for stock pickers.
Figure 12. Cross-sectional variance of returns (Man Numeric China A-Share Universe, rolling 12-month)
Source: Man Numeric, MSCI Barra.
Investors need nuanced, not naïve, quantitative models
In light of some of the risks discussed previously, investing in a simple smart beta strategy may seem imprudent. For example, a naïve value investing approach would have significant and consistent exposures to size, leverage, volatility, and liquidity (not the case in the broader emerging market universe), likely at least partly due to the impact of SOEs (Figure 13).
Figure 13. Rank correlation of Barra Value with other risk factors in China A and Emerging Markets universes
(Jan. 2010 – Dec. 2016)
Source: Man Numeric, MSCI Barra.
We believe a more sophisticated and balanced approach that aims to neutralize unwanted risks should be able to weather different market environments better and add significant value relative to a naïve approach over the long run. Simply neutralizing the unwanted size exposure from the Barra Value factor would have dramatically improved its return spreads while reducing volatility (Figure 14).
Figure 14. Simulated1 Barra Value decile return spreads
Source: Man Numeric, MSCI Barra.
Going a few steps further, the return spreads of the simulated Man Numeric China A-Share proprietary model (Figure 15), based on a diversified approach of Valuation and Information Flow models with thorough risk neutralization, would have historically been positive, despite periods of underperformance in 2010 and 2015.
Figure 15. Simulated1Man Numeric model decile return spreads
Source: Man Numeric.
Is 2018 the right time to invest?
Shanghai and Shenzhen connect programs
Since the initial launch of the Connect Program in 2014, the number of stocks accessible to foreign investors has increased significantly to about 1,500, representing about 80% of the USD 6.5 trillion total market capitalization (as of December 30, 2016). As the market opens up to a broader investor base, the behavior of mainland investors could mature, with the type of lottery effect documented in Ng and Wu (2006) subsiding along with the proportion of retail investments, potentially providing significant tailwind to investors focusing on more traditional investment principles.
Inclusion in MSCI EM Index is likely to attract international capital
After declining to add China A-Shares to their Emerging Markets Index three years in a row, MSCI decided to include them in May 2018 at a 5% partial Inclusion Factor. The improved accessibility to the China A-Share market through the expansion of the Connect programs, the decrease in the number of trading suspensions, and the loosening of pre-approval requirements for index-linked investment vehicles were decisive factors in the MSCI decision. The representation of China A-Shares in the MSCI Emerging Markets Index will be less than 1% at the time of inclusion. However, MSCI has announced it would increase its Inclusion Factor if conditions continue to improve, hence attracting more international investments.
As China, the second largest equity market in the world, finally opens up to foreign capital, it is clear to us that foreign investors can no longer ignore it. While purely passive or smart beta-type approaches have their limitations, active managers could potentially offer compelling investment solutions. We believe the China A-Share market could provide benefits to an investor’s portfolio, from a return and diversification perspective, even if risks and challenges remain. And with its inclusion in the MSCI Emerging Markets Index in May 2018, now might be a good time to take a closer look at the opportunities the China A-Share market offers to investors.
1. There exist limitations inherent with model results. All model spread performance shown is simulated and gross-of-fees; it does not represent the performance of any Man Numeric portfolio or product. Past performance does not guarantee future results. The simulated model spreads shown are decile model spreads, where we invest long (short) in the top (bottom) 10% ranked names (rankings based on Man Numeric's internal alpha scores) and display the gross return. These spread returns are instantaneously rebalanced, sector-neutral and do not reflect transactions costs. Simulated trading programs in general are also subject to the fact that they are designed with the benefit of hindsight.Download full article
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