Asset owners across the world are investigating how to begin increasing their long-term allocations to Chinese equities, following decisions by the MSCI to add A-shares into its emerging market index.

As noted here, some are doing so internally. But many investors will instead opt to use external fund managers. But picking a partner can be daunting. 

Consultants say a good way for asset owners to start is to work with fund houses they trust. 

Australia’s superannuation fund Cbus is one example. Fok said the pension fund’s research was made easier by having a longstanding asset manager partner, which is understood to be AMP Capital. It’s familiar with China, having had a QFII quota since 2006.

“We are fortunate that we had access to somebody who has invested there for a long time and has relationships, as otherwise it’s hard to go in and arrange meetings,” said Fok. “As expected you need to spend the time to know [potential investment targets]; often meetings are more introductory in nature and then you need to find opportunities outside them.” 

However, asset owners must prioritise their own needs when deciding who to partner with. 

“At a basic level there are a few decisions to be made,” said JP Morgan AM’s Wang. “First, how does China fit into your portfolio? If you have a targeted income or outcome you need to achieve, you need to look for managers that specialise in those types of investing.”

Asset owners next need to consider which stylistic preferences meet their needs. For example, stocks best predicated on China’s economic growth might well consist of consumer and bank stocks, before valuations and macroeconomic factors come into play. 

“From there you think of fund managers with a degree of expertise in that space,” said Wang. 

Picking the right partners is vital. Li of Mercer noted that there was a 50% differential in terms of investment returns between the top and bottom China fund performers in 2017. “The median is about 8% or so,” she noted. “The dispersion can be huge, so asset owners need to take the time to understand the asset managers.” 

This can include local as well as international fund houses. The governance of leading local asset managers has greatly improved over the past 10 years, as they have learned from international peers and rivals. However, “I’d say that monitoring closely your managers is very important,” said Li.

There is an abundance of potential partners available. Any overseas investor can use Stock Connect. In addition, 287 overseas institutions have qualified foreign institutional investor (QFII) quotas, which lets them invest into A-shares. 

Another 196 organisations have a renminbi equivalent, called RQFII, according to the State Administration for Foreign Exchange (Safe), which oversees the quotas. QFII had $99.46 billion in approved quotas at the end of April, while RQFII’s total was Rmb615.85 billion ($96 billion) at the end of May. Investing via QFII and RQFII is getting easier too. On June 14 Safe scrapped a rule that only let investors take 20% of their QFII or RQFII investment out of China on one day. It also permitted them to use QFII to hedge currency risk onshore for the first time. 

The changes came two weeks after MSCI’s A-share decision. Beijing appears keen to encourage foreign investor inflows. 

TACKLING VOLATILITY

Linking up with the right partners is essential, because China’s A-share market acts very differently to its equivalents in the US or Europe. 

Rumours can move stocks a great deal, while fast growing or struggling companies can be overlooked. That means that a lot of alpha can be made—or lost. Passive investing is not generally seen as the smartest approach. 

“There are inefficiencies there, partially as a result of onshore equity managers and holders on the retail side targeting disproportionately short-term outcomes,” said Wang. “They will sometimes sell a stock that looks good on a three-year view to fund one that they believe in for three months. It’s almost a time horizon arbitrage.”  

China’s market is also relatively underdeveloped in terms of derivative options, making it more challenging to hedge risk. Plus it doesn’t look particularly appealing today, at least when compared to other emerging markets. 

JP Morgan AM’s Wang noted his company has China on a neutral to negative tactical allocation. “On a simple P/E (price to earnings) basis the MSCI China Index looks optically high, while earnings revisions don’t look particularly strong.” 

The index’s P/E ratio was 15.5 on May 31, versus 14.26 for the MSCI Emerging Markets Index. 

The markets are heavily retail driven, which means that they can be very volatile.

Retail investors comprise approximately 99% of accounts and 80%-plus of market turnover, according to Huatai Financial. They tend to be rumour- and momentum-driven. This can cause big pitches and yaws, such as in 2015 when the local stock markets collapsed by almost 50% in less than three months. 

That’s disconcerting for many asset owners. “We don’t like to see a market that is very much influenced by retail investors and volatile moves. That is very important,” Jang Dong-hun, CIO at Korea’s Public Officials Benefit Association (Poba), told AsianInvestor

Volatile markets are troubling for investors requiring a minimum return. 

“We have to generate over a 5% [investment] return every year,” said Jang of Poba, which has only about 1% of its $11 billion portfolio in China shares, including those listed offshore. “So if we subject to volatility, we cannot expect our return [to reach the target].”

Yezdi Chinoy, CIO for Asia at Generali, added that market timing can make or break successful A-share investments. 

This is the second part of the cover story from AsianInvestor's June/July 2018 edition. Please click here to read the first part.