China’s flagship pension fund argues that passive investment strategies – and particularly smart-beta exchange-traded funds – will enter mainstream usage for mainland stocks, as the market's efficiency improves. And asset managers broadly agree.

The $294 billion National Council for Social Security Fund (NCSSF) last week published a report on China’s stock market, arguing that index-based factor investing would be a major trend among asset owners with lower risk appetites, such as pension funds.

NCSSF said the A-share market’s efficiency lagged that of developed stock markets and even the other four Brics economies (Brazil, Russia, India and South Africa), mainly due to China’s short period of market development and its high proportion of individual investors.

This provides active fund managers with ample opportunity to generate alpha, noted the Chinese-language report, but as A-share market efficiency steadily improves, the alpha generated is set to shrink.

Hence institutional investors such as pension funds, which have low appetite for risk, should take into account the high volatility and high cost of active funds and prepare for a shift to passive investments such as index funds, NCSSF said. It did not specify a time frame for when this might happen.

Factor flows forecast

Factor-based or smart-beta strategies – which employ index weightings other than traditional market capitalisation – also have a good chance of performing well in China, noted NCSSF. Hence, it argued, factor-based exchange-traded funds (ETFs) will likely be a mainstream investing strategy in the next three to five years.

Consequently, said the pension fund, institutions should thoroughly explore factor strategies and construct index funds that match their own risk-return demands and market styles.

It was presumably no coincidence that NCSSF’s report was published shortly before MSCI’s announcement on A-share inclusion in its emerging-market indexes. The benchmark provider said early on Wednesday morning (Hong Kong time) that it would be including Chinese stocks on a partial basis. Once full inclusion takes place, global index-based investors will be forced to allocate far more to A-shares and will be keen to see the market become more efficient and institutionalised.

Marco Montanari, Asia-Pacific head of passive asset management at Deutsche Asset Management, said his firm’s research showed that smart-beta strategies could work for China’s onshore equity market, generally speaking.

He added that he would not be surprised if large domestic sovereign entities were to invest in smart beta in China in the next five years, with local insurers and retail investors to come later. Meanwhile, foreign investors probably need another five to 10 years to assess the progress of smart beta in China, he said.

In addition, the research by Deutsche AM, which offers both active funds and ETFs, showed that smart-beta China ETFs were expected to develop around A-shares rather than offshore-listed Chinese stocks due to the larger onshore universe.

Active versus passive

However, Anna Tong, Asia-Pacific head of investments at Invesco, which also offers both active funds and ETFs, told AsianInvestor that active investing was currently the best way to play A-shares. Many of the major indices do not represent the fastest growing sectors of the economy, she noted.

But Montanari noted there were indices tracking different sectors for China market, meaning investors could target specific sectors.

A Hong Kong-based institutional saleswoman at a European active fund house argued that benchmark-huggers had damaged the reputation of active management and that the best active managers could always generate alpha.

Still, both Tong and the unnamed saleswoman agreed that in the long run, as Chinese market efficiency improved, there would be room for ETFs in the market, given their lower cost.