Why investors may want to consider an allocation to China A-shares

Apr 27, 2018

At the opening of the National Congress of the Communist Party of China in October 2017, President Xi Jinping promised “China’s open door will not be closed, it will only be opened wider.” For global investors, there is no more important manifestation of this opening up than the liberalization of China’s financial markets.

While China still has some way to go before its markets are on par with developed world standards, its reform efforts thus far have not gone unnoticed. In June 2017 MSCI announced that it would begin including Chinese A-Shares—companies based in mainland China that trade on the Shanghai and Shenzen stock exchanges—in its benchmark emerging market and global indices beginning later this year.

We’ve been investing in A-shares since 2012 given our belief that they represent fertile ground for investors looking for uncorrelated alpha in a relatively inefficient market. Now that A-shares are likely to play an increased role in institutional investors’ portfolios, we thought the time was right for an in-depth look at the market.

In the second in our series of emerging market briefings, Rui Zhao, portfolio manager for BlackRock’s Systematic Active Equity Team, discusses some of the potential benefits and risks of investing in China and explains why it may be a good time for investors looking for growth and diversification to consider Chinese A-shares.

 


Q: Many investors have exposure to China via their emerging markets or global strategies. What's the case for a standalone allocation?

A: Given the sheer size of the market, the favorable demographics, and the potential for strong economic growth, we think a China-focused strategy is worth considering for investors looking for long-term growth.

Even if investors have China exposure through an EM or global index strategy, or through an active fund that is benchmarked to an index, they’re not getting exposure to the full market opportunity. The leading indices have historically only included Hong Kong-listed H-shares, which are heavily concentrated in the financial and technology sectors. Investing in A-shares can help open up a broader opportunity set. For example, we think one of the most exciting stories in China is the rise of the domestic consumer, and A-shares give investors significantly greater exposure to the consumer staples, consumer discretionary and healthcare sectors. See the chart.

Different exposure

Sector allocations of MSCI China (H-shares and ADRs) vs. China A-shares

Different exposure

Sources: MSCI Research, China Statistical Bureau, China State-owned Assets Supervision and Administration Commission, March 2018. Indexes are shown for illustrative purposes only. Indexes are unmanaged. It is not possible to invest in an index.

We’ve been investing in A-shares since 2012, but the market is still dominated by retail investors.  That’s going to change, however, as MSCI is about to start including A-shares in its main global indices, although the process will play out over many years.

Q: How does the fact that the A-Share market is dominated by retail investors impact your investment process?

A: It influences our process in some pretty interesting ways. Not only is China a retail-driven market, it’s also a country that has really taken to social media. WeChat surpassed 900 million daily active users in the fourth quarter of 2017, according to its parent company Tencent. And retail investors love to use social media to discuss markets and investing.

Social media posts contain a tremendous amount of data about investor sentiment. Of course, that data is unstructured, so we need to use a different set of tools to analyze it. We’ve developed machine-reading algorithms that can make sense of this very large and unruly body of information and provide us with meaningful insights into what retail investors are thinking and doing.

Q: In markets that are more institutionally driven, retail sentiment and flow are often viewed as contra-indicators. Is that the case in China, or is the reverse true?

A: It’s actually not black and white. On an aggregate basis retail investors tend to chase returns, so they are often late to a story. But if you can understand daily sentiment on a relative basis—say, whether investors are more positive on one sector of the market versus another—that can be a powerful leading indicator.

And the process is even more granular than that. For example, an increase in positive sentiment on a stock tends to be a positive indicator, but if we see a massive one-day spike in enthusiasm, that’s more of a negative.

I’d also add that as markets and investor behaviors shift, the process for measuring sentiment needs to evolve. We can’t just develop a sentiment signal and assume that because it worked today, it’s going to work tomorrow. That’s why we’ve invested heavily in machine learning to help us spot patterns and to see how they change over time.

Q: Besides social media posts, are there other data sets that you find particularly useful in China?

A: Company disclosures are another rich source of information. While China has sometimes been portrayed as an opaque market, it actually has some very strict disclosure rules. For example, when fund managers meet with a publicly traded company, the company is required to publically disclose, on the Internet, who attended the meeting and what was discussed.

The goal of the regulation is to make sure that individual investors have access to the same information as professional money managers. But it’s also opened up another avenue for our machine-reading algorithms to tap into a potentially valuable data source that doesn’t exist in many other markets.

Q: You mentioned up top that MSCI is adding A-shares to its main global indices. How will that affect your process, and how should institutional investors approach the change?

A: For us, as systematic investors, I think one of the most significant consequences will be the increased presence of institutional investors. And not just index investors, but active managers as well. Because if you’re an active manager benchmarked to an MSCI index, you’re now going to have to consider investing in A-shares as well.

Institutional investors take a very different approach than retail investors—institutions tend to focus more on company fundamentals. We have a whole host of fundamental signals that we use, in addition to some of the sentiment signals that we’ve been discussing. Ultimately, we want to combine fundamental and sentiment signals in a fairly balanced way, so I think having more fundamental investors in the market will be a positive for our approach.

As far as how investors should treat the change, that, of course, will vary by institution. MSCI is going to start by including companies at just five percent of their market-cap weighting, which translates to an A-share weight of less than one percent in the MSCI EM Index. But we expect that percentage to increase over time, especially if China continues with market liberalization. If companies are eventually included at their full weight, they’ll make up a significant portion of the index. If you think that’s going to happen, there’s a strong case to be made for starting to invest before all of that money comes into the market.

Q: What are some of the risks that investors should consider? Is excess leverage in the financial system a cause for concern?

A: I think the biggest risks are geopolitical. North Korea, in particular, has the potential to be a destabilizing force in the region, and trade tensions with the U.S. are extremely high given the recent announcements on tariffs. These types of risks have historically been difficult to model, but we’ve found that using text analysis of news wires and brokerage reports can help us get a better handle on the severity of certain geopolitical risks and to adjust our positioning if need be.

The question of leverage is a valid one. China has experienced tremendous growth in leverage since the financial crisis, and we’ve certainly seen some excesses in the Chinese financial system, but the government is beginning to address them. The China Banking Regulatory Commission (CBRC) launched a campaign against financial leverage in April 2017, and by August Chinese banks’ leverage had fallen for the first time in seven years, according to CBRC figures.

We think the deleveraging process still has a long way to go, and in the short term that could lead to some increased volatility and to some air coming out of certain segments of the market. But if you take a long-term view, which we definitely do, then deleveraging looks to be a positive. If China can reduce the amount of leverage in the financial system without throwing a wrench into the engine of economic growth, I think both the financial system and the economy may end up more resilient.

I’d also add that the abolition of term limits and the consolidation of power under President Xi Jinping is something investors need to consider. While it’s possible that this could lead to some problems down the road, I think it will allow for some pretty decisive policy change, whether it be deleveraging, cleaning up corruption or enacting supply side reforms that curtail excess production. If these things happen more quickly than markets are expecting, investors need to consider the possibility that, instead of exporting deflation to the rest of the world, China could become a source of inflation. That would be a real game changer.

Q: How can institutional investors incorporate a China strategy into their portfolios?

A: I think China should be viewed first and foremost as a long-term investment strategy. Many of the trends we’ve been discussing, from market liberalization to deleveraging to index inclusion, are multiyear stories. We believe that they should provide tailwinds for investors, and that China’s economic growth will continue to be stronger than most developed, and many emerging, markets.

To realize the potential long-term benefits, investors do need to be comfortable with the possibility of large short-term market swings as China has exhibited higher volatility than many other equity markets. But the flipside to that higher volatility is the fact that Chinese A-shares have displayed low correlations with leading global and regional indices, so adding A-shares to a global portfolio can actually decrease total portfolio volatility. See the chart.

A different drum

Correlation of China A-shares with select indices

A different drum

Sources: BlackRock, Bloomberg, 5Y 20-day correlation, March 2018.

Rui Zhao
Lead Portfolio Manager for China Opportunities Strategy