Institutional investors looking to increase investments in China need to weigh carefully how they do so, particularly with regards to broader emerging market allocations, if they are to avoid portfolio inefficiencies or unnecessary risks, says investment consultancy bfinance.
A new study by the group released on Thursday (June 25) looked at several options for investors to access China’s A-shares market. As the report noted, while the coronavirus originated from China, its markets have enjoyed relatively good performance versus global ones.
While the MSCI Emerging Markets index lost 23.6% in the first quarter, the MSCI China A index (focused on A-shares) lost just 9.72% and the MSCI China index (based mostly on offshore China equities) lost 10.22%.
That underlines the diversification strengths that a good China investment can bring. And most asset owners remain underweight on China, particularly given the size of its economy in the world.
But as bfinance noted in its report, “there are multiple approaches for achieving Chinese equity exposure, each of which brings advantages and disadvantages”.
It noted that three potential routes included investing in China via a broader global emerging markets strategy; or creating a dedicated A-shares allocation alongside a broader existing global emerging markets allocation; and lastly adding a dedicated A-shares allocation with a non-China emerging markets strategy.
Each offer advantages and disadvantages, according to bfinance. A broad GEM strategy that includes China is the simplest, with easiest oversight and a slowly rising proportion of Chinese weighting as indexes such as MSCI Emerging Markets increase the inclusion of Chinese shares. However, this approach lacks expertise, is often biased to a few large caps onshore, and is underweight promising areas such as consumer staples on healthcare.
The second approach, a broader GEM strategy and a small dedicated A-share portion (bfinance used an 85/15% split as an example) has its own pluses and minuses. A key advantage is the ability to choose between many A-share managers to access and direct the A-share portion and target it where the investor wishes. On the negative side, when the exposure is divided between onshore and GEM managers it limits the ability to express relative value views.
The third approach, an ex-China GEM offshore split and dedicated onshore investment (with perhaps a 55%/45% split) helps unify all China exposure to take advantage of onshore and offshore values and allows the investor to target promising areas. But there are few GEM ex-China products, which can prove a challenge for this approach, said bfinance.
“Over time, we anticipate a continuing migration away from obtaining China exposure solely through GEM strategies and towards China strategies, particularly those with a strong onshore focus,” bfinance said, noting that this will also depend on how much China exposure investors want in their portfolios and whether they desire it through onshore or offshore means.
The likely rise of investors seeking a dedicated China exposure particularly suggests an interest in A-share investments, as these require a more focused approach using A-share investing experts.
It also suggests taking an active management approach as opposed to using an index, due to the fast-changing economy of China, and a large level of information inefficiency in the market and a relatively low institutional investor involvement, leading to more volatility.
“The average A-shares manager has delivered 5.5% per year over the last five years (to March 31) versus -6.2% for the index,” bfinance’s report noted. “In comparison, the average China equity manager (largely offshore, benchmarked against MSCI China) has delivered annualised returns of 5.3% versus 3.6% for the index.”
But while active China investments, at least with highly regarded fund managers, appears to offer demonstrable advantages, bfinance offers a common caveat for the country’s share market: its retail investor domination makes it a fickle, sometimes illogical place to invest.
“Managers focused on company fundamentals can underperform in momentum-driven markets, with retail investors often trading based on news and social media,” said the report. “Domestic China asset managers are also a source of short-termism: their performance rankings are widely publicised, affecting flows from retail investors.”
Add to that the lingering levels of concern about potential fraud, a very different regulatory structure, and the fact that “2020 has already seen President Trump ordering the US Federal Employee Retirement Fund not to invest its assets in Chinese companies”.
Despite this, asset owners across the world look set to invest more in China A-shares. But as bfinance’s report reveals, they will have to carefully consider how to do so.
Look out for AsianInvestor’s coming 20th anniversary edition, in which we delve more deeply into the likelihood that international asset owners will invest more into A-shares over the coming decade.