The time is right to use China A-shares to optimize equity mix

May 04, 2020 08:58
Photo: Reuters

The opening of the China A-share market to foreign investors—and the subsequent growing inclusion of a much larger number of Chinese companies in widely used equity indices—is poised to be, in our view, one of the most transformative events in the financial markets over the next decade. The implications for investors are numerous, complex and, above all, inevitable, making the maintenance of the status quo, in our view, an unviable solution.

Our analysis shows that the Chinese domestic market exhibits low correlation with other widely held asset classes (such as Hong Kong-listed H-shares as well as US and European equities), a trait that stems from the fact that; a) the Chinese domestic market is influenced by unique economic, political, and monetary policy considerations, and; b) it has very different market participants than elsewhere. In addition, because these companies generate the vast majority of their revenues domestically, the effects of ongoing trade tensions with the US are less pronounced than may be commonly assumed.

China A-shares and the promise of the “new economy”

Now the second-largest economy globally, China is forecast to overtake the United States as the world’s largest economy by 2030. That growing economic importance will increasingly be reflected in global equity indices and in portfolios. Further, adding China A-shares to portfolios adds meaningful diversification, as evidenced by China A-shares’ low historic correlation with major equity markets globally.

In addition to the low-correlation factor, the China A-share market provides an entry door for investors to more deeply benefit from China’s ongoing shift from an export-driven economy into the so-called “new economy,” characterized by an increased role of domestic consumption and higher- value-added sectors, such as tourism, entertainment, healthcare equipment, industrial automation, new energy vehicles, biotech, software and new materials.

In fact, more than half of China’s economic output comes from the services sector, and the country is a major investor in, and adopter of, digital technologies. So, China A-shares—especially when accessed through non-passive instruments—better reflect the promise of the country’s digital future than emerging-market benchmarks such as the MSCI Emerging Markets Index, which is highly biased towards Chinese mega- and large-cap stocks.

Understanding and mitigating China A-share risks

While the China A-share market represents a significant opportunity, it carries risks. We expect that the increased access to China A-shares and the rising importance of the country’s economy will attract greater participation from investors. Nevertheless, the market for now remains dominated by retail investors. Indeed, domestic retail investors, primarily focused on chasing short-term trading profits, account for more than 80% of daily turnover. Also, local Chinese equity analysts tend to be less experienced than is the case in developed markets, leading to a greater frequency of earnings surprises than in more mature markets.

Those risks, however, are characteristic of many developing markets, and they tend to dissipate as the market matures. On balance, we believe that the time has come for investors to consider a dedicated allocation to China A-shares, especially since, as noted previously, the asset class can offer a significant source of diversification for global stock investors. The opportunity set is substantial, especially for investors seeking to optimize their equity exposures.

We believe that active management can help investors to properly exploit the China A-shares market’s inefficiencies to generate potential outsized returns in general, and alpha, in particular. Just as important, however, active management can generate potential outperformance not only by selecting the highest performing stocks but also by avoiding problematic ones.

This is especially true when investing in a still-developing marketplace, with volatility levels that are higher than in developed markets. In the Chinese domestic market, potential downside protection is as critical as potential upside reward.

Deploying China A-shares in an institutional portfolio

In light of the current opportunity and the early stage of development of the China A-shares market, we believe that adding a more significant allocation to China A-shares as part of a portfolio’s current emerging-market allocation makes sense for both risk-return reasons and for portfolio optimization, especially given the asset class’ low correlation to other global equities.

The question then becomes, how heavily should an emerging- market allocation tilt toward onshore China? While the precise answer varies among investors, data suggests that the sweet spot may be between a 10% to 30% direct allocation to China A-shares, with the money to fund that allocation coming from investors’ existing emerging-market portfolios.

Our analysis reveals that shifting 10% of one’s global emerging-market allocation to China A-shares would improve the overall portfolio return from an annualized 7.5% to 8.3%. And, mainly due to the asset class’ low correlation characteristics, the portfolio’s Sharpe ratio would see a significant enhancement from 0.29 to 0.34.

A bolder shift of 30% of one’s allocation to China A-shares would compound the enhancements further, with the annualized return of the overall portfolio rising to 9.7% and the Sharpe ratio jumping to 0.4. Our 15-year historical risk/return analysis suggests that a portfolio’s Sharpe ratio would be maximized with an allocation of 50%. While any such historical analysis is very dependent on its start and end points, these results suggest that a meaningful allocation to China A-shares would be beneficial from a portfolio construction perspective.

The historical analysis highlights many of the benefits that investors can reap from allocating to the Chinese onshore equity markets and, we believe, can be used as a starting point when considering exposure to the asset class. Further, we recognize that historical analyses are very start- and end-point sensitive. Those caveats notwithstanding, history and experience have shown us that the Chinese domestic equity market is clearly on an evolutionary path, especially in terms of its outlook for broader investor participation and potential lower volatility.

With investors being able to access the domestic Chinese economy with relative ease through Stock Connect programs to invest in China A-shares, giving them the ability to harness the promise of an increasingly consumer-driven “new economy”—one that is set to grow into the world’s largest economy within a dozen years.

We believe that the time is right for investors to consider increasing allocations to onshore China. That can be achieved by investors altering their existing emerging-market allocations to add direct allocation to China A-shares in order to better position portfolios for the intermediate and long term. Historical data suggests that doing so could improve returns and may also diminish risk, making it a compelling portfolio optimizer.

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Portfolio Manager on Chinese stocks, Allianz Global Investors