Why investors must be nimble to navigate Chinese stocks
Investing in emerging market (EM) assets brings with it various, distinctive risks. When it comes to China, the country’s scale and political system give equities investors and bondholders more issues to weigh-up than almost anywhere else when making any allocation decision.
From managing risk and liquidity, to addressing ongoing volatility and uncertainty in terms of markets and policies, an active approach seems essential.
In this piece, William Chuang, Portfolio Manager, Asia Equities, explains the key considerations for investors interested in China, including how to navigate this ever-changing landscape.
Q. The recent headwinds in the internet and e-commerce space – as seen with Alibaba – are the latest reminder of the idiosyncratic risks for investors in China. How can you manage these?
William Chuang: We do this in several ways. For instance, the maximum weighting for any position we hold in our portfolio is 6%, even if its benchmark weight is over 10%. We believe this protects investors from benchmark concentration risk.
More broadly, understanding the priorities of policymakers is particularly important in China. We therefore constantly assess policy initiatives and their potential implications to various sectors/industries. We then try to identify ‘winners’ that could benefit from these changes.
Ultimately, alpha – in our experience – can come from anticipating these policy/paradigm changes. Hence, precisely because of this idiosyncratic risk, actively managed China funds on average have consistently outperformed the benchmark.
In the case of Alibaba, it is worth noting that China’s tech sector is simply mirroring similar regulatory pressures that ‘big tech’ is facing around the world.
The below Morningstar data (Exhibit 1) that looks at all China equity funds shows an average return that outperforms the index across most of the periods sampled, and with lower volatility.
In our own experience, the investment process we apply for our thematic equity strategies has also shown an effective ability of identifying structural growth stories and filtering out names that are more likely to underperform.
Exhibit 1: Performance of MSCI China Index vs. Average of all China Equity funds (net of fees)
Source: Morningstar, as of Jan 1, 2021
Q. To what extent is liquidity in the A-shares market of any concern, especially given arbitrary ‘suspensions’ of trading as we saw in 2015?
William Chuang: This is a valid concern which has been in the spotlight for several years. MSCI also flagged this issue as one of the arguments against the inclusion of A-shares into the MSCI initially.
However, China has made significant progress in recent years. For example, in 2016, both of China’s main stock exchanges announced a maximum suspension term of three months for companies involved in major asset restructurings, and one month for companies in the process of private placements. Then, in 2018, the two exchanges further tightened the rules by shortening the suspension period for major asset restructurings to 10 days, with no suspension allowed if the restructuring doesn’t involve the issuance of shares.
We have seen significant improvements since these new regulations were implemented (Exhibit 2). And we expect to see further improvements in this area as China continues to reform and liberalise its financial markets.
Exhibit 2: Number of suspensions in A-share market slumped in recent years
Source: CLSA, Wind, as of Jan 2021
Q. Have any of these reforms also helped to address concerns over volatility in A-shares?
William Chuang: We need to look at the retail and institutional perspectives. Despite what some people think, the high retail ownership ratio is not the main issue; instead it is due to their relatively high representation in daily trading volumes. A recent Tencent report1 concluded that the retail investor base is getting more educated and sophisticated, which is a good sign for the market’s evolution.
There is also a clear trend of ‘institutionalisation’ in liquidity. The below chart (exhibit 3), for example, shows that as of last year, financial institutions comprised nearly one-quarter of the investor base for A-shares, up from only 10% in 2007.
Source: Bloomberg, Shenzhen SE, BofA Securities
More specifically, if we look at the volatility of the CSI 300 over the past decade, it averages around 22%. Today, we are below that, at around 20%2.
Further, as the domestic market continues to develop, with increasing participation by both foreign and local institutional investors, there is certainly scope for the average volatility to trend lower.
Q. This, of course, doesn’t address FX issues. A lot of Chinese stocks are denominated in US or Hong Kong dollars, but revenue for most of these companies are based in renminbi (RMB), creating heightened sensitivity to RMB depreciation. How can investors manage this risk?
William Chuang: There is no doubt that the US dollar / interest rate environment is an important consideration for EM equities as a whole, including for Chinese equities. However, the real operating risk to companies is hard to generalise.
In our experience, Chinese companies typically hedge their exposure if they have a good visibility on what that exposure will be. Where possible, they might also try to localise operations to better match cost versus revenue. Further, most companies that import raw materials will manage this risk through inventory management and hedging.
In addition, a weaker RMB is a positive for some companies. Historically, in periods of RMB depreciation, we have seen consumers spend more domestically as they do less traveling overseas or buying fewer imported goods. The resulting import substitution effect tends to be positive for many domestically oriented themes.
At the same time, China started to peg the RMB to a basket of currencies just over five years ago, with the goal of creating more currency stability3.
However, in line with our approach to actively manage investments in China, we monitor trends of the RMB and assess when it could have a material impact to companies’ we monitor. While it is complicated and challenging to hedge in the short term, we find that the currency impact is of lesser importance than the company fundamentals over the long term.
For 2021, we believe the RMB will remain stable. Yet with other countries resuming production activities and vaccines being rolled out, China’s trade surplus may decrease, and the US-China interest rate spread may narrow. These trends might limit the yuan’s upward trend. Our economists expect the USD/CNY rate to range from 6.4 to 6.5 this year.
Q. Based on all these views, what is the future role for Chinese equities within the asset allocation of foreign investors?
William Chuang: The inclusion of A-shares into the MSCI Emerging Markets index in 2018 was a huge first step for Chinese onshore equities stepping into the international arena. (Exhibit 4) Currently, China’s total weighting in the MSCI All Country World Index (MSCI ACWI) is 5.3%. Of the 653 Chinese constituents, 467 are A-shares, with this group accounting for just 0.65% (roughly 13% of China’s current weighting).4
Exhibit 4: Development of China’s weighting in MSCI’s Emerging Markets index since before A-share inclusion in 2018
Source: MSCI, as of Oct 2020
While it’s difficult to specify a fair weighting for China in the MSCI ACWI, we can compare it with Japan, whose weighting is 6.8%. Given that China’s GDP is 1.8 times that of Japan, plus the former is growing faster, it is plausible we will see China’s weighting rise to 8%-10% of global equities over the next decade. Also, China already accounts for 15% of global market capitalisation and for 14.5% of global GDP.
Although MSCI conducts four reviews per year, the evaluation of China’s A-share’s further inclusion and constituencies could happen at any time. Before then, Chinese regulators need to address concerns within MSCI about areas such as hedging instruments, settlement cycle, and banking holiday and trading alignment.
We expect these issues will be addressed over time. For example, the omnibus trading issue (enabling trading for multiple clients’ accounts through a single order) is being worked on at the moment, with a solution possible by mid-2021.
Based on these reasons, we are confident foreign investors will continue to increase their China allocation.
 Bloomberg, MSCNAL HVG, as of Jan 15, 2021
 Bloomberg, as of 2/3/2021