It’s best to play China through actively managed strategies because they can harvest the inherent inefficiencies in emerging markets – or so many investors would argue.

Yet new research from Morningstar suggests that may not always be the case, and certainly not in the past few years – at least when it comes to a large swathe of local products.

As of mid-2019, fewer than half of active China-domiciled broadly diversified stock-heavy funds had outperformed their average passive peer over one, three and five years.

This is heavily down on previous years, given 70.8% of active managers outperformed their average passive peer in the 10 years to June 30. The most recent period saw the biggest drop, with just four in 10 active funds beating the passive composite in the 12 months to mid-2019 (see chart below).

While this is a “rare situation” in mainland China, it is likely to happen again, albeit depending on the market, Andy Huang, a senior research analyst at Morningstar, told AsianInvestor.

He cited two reasons that could partially explain the low recent success rates of active managers.

For one thing, their average 13% cash position may have hurt performance amid a strong rally in the A-share market in the first half of 2019. Moreover, active growth funds continued to face stylistic headwinds in the first half of the year as large-cap value stocks generally outperformed small- and mid-cap growth stocks.

CHINA STOCK-HEAVY FUNDS' PERFORMANCE AND SUCCESS RATES
(Click for full view)

The study also provides further food for thought for investors mulling whether to go active or passive in China – and perhaps also for the crowd of foreign fund houses building local investment capabilities there.

The average renminbi invested into passively managed funds has tended to outperform that invested in actively managed stock-heavy funds, Morningstar said. This is despite the fact the average active fund has tended to outperform its average passive peer, especially over longer time frames.

The point is that investors have generally failed to choose above-average active stock-heavy funds. Across all three periods calculated in the study (those ending mid-year 2018, year-end 2018 and mid-year 2019), active funds’ equal-weighted performance exceeded their asset-weighted performance over the trailing one-, three-, five- and 10-year periods.

Investors have had done better in picking above-average passive funds, as passive funds’ asset-weighted performance exceeded their equal-weighted performance over the trailing one-, three-, five- and 10-year periods.

Certainly, passive investment into China is growing more popular generally. The total amount of assets held in exchange-traded products providing exposure to the country stood at $106.3 billion as of yesterday (October 28), up from $62.4 billion at end-2016 and $85.6 billion at end-2018, according to research house ETFGI.

So could the recently declining success rates for active funds suggest the Chinese market is getting more efficient and, therefore, a more difficult place to generate alpha?

It is hard to say that the markets are getting more efficient just by these results, Huang cautioned, and the trend may reverse depending on market shifts.

“Active managers may find it more difficult to outperform index funds as the market matures over time,” he added, “but in the current market, they still have the potential to generate alpha.”

MORNINGSTAR STUDY METHODOLOGY

The Morningstar China Active/Passive Barometer covers 1,009 and 1,099 unique active and passive China funds that account for Rmb1.06 trillion ($153.8 billion) and Rmb1.36 trillion in assets as of the end of 2018 and mid-2019, respectively.

To measure active managers’ success, the barometer evaluates active funds against a composite of actual passive funds (not a costless index). In this way, the “benchmark” reflects the net-of-fee performance of passive funds.

This study did not examine active funds’ success by fee level as there are insignificant fee differences among active funds in China, said Morningstar.