If China is under-represented in global benchmarks and portfolios, how much exposure do you need? Unfortunately, there is no easy answer.
While China’s share of global GDP is 16%, there is no link between the size of an economy and its share of global capital markets or of investment portfolios. For example, the US economy’s share of global GDP is 24.1% yet it comprises 54.4% of global stock market capitalisation.
In addition, even on the most optimistic scenario, China’s equity share of global market cap is only 12.1%, while index provider MSCI puts its investable market cap at 5.4% (reflecting free-float and foreign ownership limits).
When deciding on their China exposure, investors need to look across global equities, emerging market equities, hedge funds and private investments.
A total portfolio allocation to Chinese assets of 5% to 10% seems reasonable, some portion of which should be invested via dedicated China managers. This approach also recognises that ‘true’ portfolio exposure may be twice as large in light of indirect exposure to China via non-Chinese investments.
Many investors could raise their exposure. In early 2018 we surveyed 37 major endowment and foundation investors on their allocations to Chinese assets across all public and private asset classes and managers. The median allocation was 5.9%, mostly through public and private equity, with limited holdings in hedge funds and fixed income.
In equities, dedicated active managers in China have the potential to add value. Its A-share market is volatile and retail-driven, and has over 3,000 small-cap stocks. Retail investors account for about 80% of A-share turnover and nearly 30% for Hong Kong-listed H-shares, versus 15% in the US.
The scarcity of domestic institutional investors results in greater market inefficiency and dispersion than in other markets and may boost opportunities for dedicated active managers. And there are managers with credible and impressive track records.
Fifty-five percent of institutional China A-share managers outperformed their benchmark net of fees over the past five years (versus 16%, 30%, and 52% for actively managed US large-cap, global, and emerging market mutual funds, respectively).
There are similar arguments for private assets. China provides diversification to typically US-centric global private equity and venture capital portfolios, and private investments offer opportunities not found in China’s public markets, especially in technology, healthcare and consumer sectors. Plus there are more institutional-quality managers with compelling track records, and China’s venture capital ecosystem may rank second only to the US. Nonetheless, valuations today are higher for private than for public equities.
We are less supportive of dedicated fixed-income allocations. Government bond yields offer little buffer against further renminbi depreciation, while hedging costs may reduce returns. Global bond, EM debt, and Asia private credit strategies appear the best avenues for Chinese fixed income and credit.
RISK VS. REWARD
Many investors are hesitant to invest in Chinese assets over fears about its legal system and foreign investor protections.
True, the quality of corporate disclosure and accounting standards are lower than global norms, and China’s legal system is not transparent or independent. But emerging market investors face similar risks in other jurisdictions, and China is improving the regulation and integrity of its capital markets. However, investing in China involves an extra layer of risk, and active management is key to help navigate a complex and volatile market.
Despite the negativity and uncertainty facing China, we see opportunities for long-term investors – especially considering the quality of the manager universe (both public and private) and current market valuations.
China’s weight in global benchmarks will rise in coming years, and today most investors are underweight on the country. They should think about their current and future allocations to Chinese assets.
This edited and abridged article originally featured in AsianInvestor's Spring 2019 magazine. The full version of the Cambridge Associates report can be found here.