Insights

Chinese equities: Is 3% enough?

Oct 25, 2018

Although China’s economy is an important engine of global growth, most institutional investors have only minimal exposure to Chinese equities. MSCI’s landmark decision to begin adding Chinese A-shares to its benchmark emerging market (EM) and global indexes earlier this year has prompted many to rethink their positioning. But even with the addition of A-shares, China’s weight in the MSCI All Country World Index (ACWI) is still only 3.4%, as of October 2018. Investors need to ask themselves whether this is a sufficient allocation to the world’s second largest stock market.

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For many, we believe that it isn’t. China’s market cap far outweighs its representation in global indexes, so an allocation of only 3.4% represents a significant underweight. See the Underrepresented table.

Underrepresented

Global market cap and index weights of leading ACWI constituents

Underrepresented

Sources: World Federation of Exchanges, MSCI, August 2018.

As of October 2018, MSCI is including A-shares at just 5% of their adjusted market cap, which results in a weighting of 0.7% in the EM Index and 0.1% in ACWI. In September 2018, MSCI announced that it was considering quadrupling the adjusted market cap to 20% by August 2019, which would increase A-shares weighting in the EM index to 2.8%. If A-shares are eventually included at their full adjusted market cap, they would make up approximately 16% of EM and 2% of ACWI.

We think that MSCI’s actions are reflective of the fact that Chinese authorities have heeded some lessons from the past, and that they are committed to further liberalizing and opening the country’s financial markets, after their heavy-handed and ultimately counterproductive interventions in equity and FX markets in 2015 and 2016. If China continues with the process of bringing its capital markets in line with developed world standards, we expect the country’s weight in global and EM indexes will grow commensurately.

Beyond the numbers, there is a host of reasons investors may want to increase their exposure to China, and to A-shares in particular. The Grade A chart below looks at how reallocating varying percentages of a hypothetical EM portfolio to A-shares would have affected performance since 2004. The results? As investors increased their allocation to A-shares they would have realized incrementally higher returns and lower volatility.

Grade A

Hypothetical return and volatility of a portfolio with varying allocations to an MSCI China-A Onshore Index strategy and an MSCI EM Index strategy, December 2004 – June 2018

Grade A

Source: MSCI, based on weekly data from December 2004 – June 2018. The values on the x-axis represent the hypothetical allocation to the MSCI China-A Onshore Index; the remainder of the hypothetical portfolio is allocated to the MSCI Emerging Markets Index. For illustrative purposes only. It is not possible to invest directly in an index.

The reduction in volatility may seem counterintuitive given the high realized volatility of Chinese equities, but A-shares low correlations with global equities make them a diversifying addition to a global or EM portfolio, and even to a portfolio of China H-shares, which currently make up a large percentage of China exposure in benchmark indexes. See the Marching to a different beat table.

Marching to a different beat

Correlation of China A-shares with MSCI ACWI, EM and China H indexes, December 2004 – June 2018

Marching to a different beat

Source: MSCI, based on weekly data from December 2004 – June 2018. Correlations are not inclusive of the entire equity universe. MSCI ACWI is shown as it is a broad-based, heavily followed global index; MSCI EM is shown as China is a large component of this index; MSCI China H is shown as H-shares make up a significant portion of the Chinese stock market.

While many investors have historically avoided A-shares due to difficulty accessing the market, restrictions on capital mobility, and uncertainties about taxes, things are beginning to change. Chinese policymakers and regulators have enacted a series of reforms aimed at bringing the A-shares market more in line with developed world standards, and in doing so have opened a new avenue for international investors to access important, and fast-growing, sectors of the Chinese economy. According to MSCI data as of October 2018, A-shares have significantly higher weightings than H-shares in the consumer staples, consumer discretionary and healthcare sectors, providing investors with greater exposure to one of the most dynamic stories driving China’s growth: the rise of the domestic consumer.

Although A-shares and the broader Chinese equity market have swooned lately amid simmering trade tensions with the U.S., we think they can offer long-term investors meaningful potential benefits. Given the diversifying characteristics of A-shares and their low current weightings in benchmark indexes, investors may want to consider a targeted, standalone China A strategy, rather than relying on their broader emerging market or global mandates to deliver their full China exposure.

The above analyses are based on reallocating into an A-shares index strategy, and all the standard reasons for choosing the index approach—low fees, ease of implementation, reduced governance costs—apply in China. But for institutional investors with the resources to pursue an active approach, we believe A-shares offer potentially fertile ground. The median active China A-share manager’s excess annual return was 5.7% over the 10-year period ending in June 2018, according to eVestment, which is more than four times the excess return of the median active EM or ACWI manager.

We believe in the future, a China Allocation of only 3% may come to be viewed not as the norm, but as a relic of a bygone era.

Part of the appeal for active managers is the fact that the A-shares market is relatively inefficient and is currently dominated by retail investors. Retail investors in China are huge users of social media—WeChat had more than 900 million daily active users at the end of 2017, according to its parent company Tencent—and their posts contain a wealth of data about market sentiment. That data is unstructured, but we’ve developed machine-reading algorithms that can make sense of it and provide us with important insights.

Of course, there is no greater truism in investing than “past performance does not guarantee future results.” But we believe there are reasons to be optimistic about the future of Chinese equities. In the past, equity returns have not kept pace with the breakneck growth of the Chinese economy. This is due in some part to the fact that much of the boom in China has been investment-led. In financial statement terms, an investment-led boom implies that profit growth is disproportionally driven by the growth of corporate balance sheets.

But the composition of China’s economic growth is shifting away from investment toward consumption. This trend is reflective of the government’s efforts to put the Chinese economy on a more sustainable medium-term path. As investment tails off, more free cash flow will be available for distribution to shareholders, and China’s potential increase in free cash flows comes at a time when valuations in the Chinese equity market have sunk along with share prices. For these reasons, we believe China’s future growth is likely to be much more stock-market friendly than it has been in the past.

Of course, risks still abound. Not only does China need to manage the shift to a more consumption-driven economy and to withstand the current trade ructions, it also must continue to take steps to address excess leverage in the financial system and to cool a property market that appears elevated. But given the potential benefits of A-shares and their low weighting in both EM and global indexes, we think the case for a long-term, strategic allocation in excess of current index weights is a compelling one. If China can successfully confront its challenges, investors with a dedicated allocation to A-shares could potentially benefit meaningfully.

Importantly though, we believe that the current opportunity in A-shares is a temporary one. The benefits of diversification and the strong performance of active managers will likely erode as the market continues to open for institutional investors and MSCI increases the weight of A-shares in EM and other global indexes. We believe in the future, a China allocation of only 3% may come to be viewed not as the norm, but as a relic of a bygone era. Investors that embrace this view today may gain a significant first mover advantage by adjusting their portfolios accordingly.

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