At the time of writing, the World Health Organisation had just declared COVID-19 a global pandemic with US equities having entered a bear market. While we understand the concerns around the economic fallout post this health crisis, markets will eventually return to normal and cooler heads will prevail. When that happens, we need to consider the longer-term investment trends as opposed to events. Investing in China directly is no longer a choice of whether one wants to invest in the market or not, it is a matter of how you position it, which will impact longer-term investor outcomes.
Over the last five years, the Chinese capital market regulator CSRC has been continually improving its dialogue with the world and finding new methods to open up the market. In 2018, the Hong Kong Shanghai and Shenzhen Stock Connect programs were opened which allowed another pipeline of foreign money to enter into the China A-share market. The majority of growth in overseas participation in the A-share market has been via the Stock Connect program as seen below.
Given this development, MSCI made the decision to include the China A-share market as part of its indices with an initial weighting of 0.1% and 0.8% in the MSCI All Country World and Emerging Markets indices respectively. By the end of the year, these weightings increased to 0.4% and 3.3% respectively.
The approach MSCI have taken in addition has been very measured and has utilised the “factor weighting” theory. What this effectively means is that most indices weight their constituents based upon market capitalisation. With some concern around being able to get into the positions, given the A-share market is not fully open as compared to say Hong Kong, MSCI had to discount the company’s underlying market cap to ensure investors would be able to get the allocation they needed to match the benchmark. This factor weight grew from 5% to 20% over the course of 2019.
The consequences of this have been two-fold. Firstly, lets address the passive flow positives and negatives. There is a now a default position where funds which are either 100% passive or are benchmark relative have been over the course of 2019 building up positions in the A-share market. The positive news is that this then dilutes retail investor participation in the market, and these are the ones who drive up volatility and are known as the ‘traders’.
Foreign investors on the other hand especially institutions are longer-term investors which will assist in driving down overall volatility. Why is this important? Because volatility in investing in China has been one of the biggest bugbears of foreign investors over history.
Now the negative – as we have monitored the flows into the market, it is very interesting to see where they have landed. The focus seems to be in mega-cap stocks which has led to overcrowded trades. This reflects the immediate reflex of keeping up with the indices. From our perspective, we believe many of these companies are overvalued and leading up to the end of 2019 provided us the opportunity to rotate out of these into better value options.
This leads to the key question – how are managers doing their research in China and how does that feed through to their idea generation and execution strategy? Traditionally, investment managers have arrangements with their brokers where, given a level of support for their services, they would receive sell side research to assist their own research efforts. While fundamentally there is nothing wrong with this approach, investors must understand that sell side research is driven by its own motivations and need to view it from that lens.
These types of arrangements have now effectively ended with the advent of MIFID II. What most financial advisers don’t realise is that these changes started in January 2018. So, what is MIFID II? MIFID stands for Markets in Financial Instruments Directive which is a framework set out by the EU. MIFID II fundamentally changes the interactions between investment managers and their execution partners whereby prior to January 2018, research and execution were bundled up into one package (without an explicit charge for research), but now it needs to be unbundled. Why is this important and what does it have to do with investing in China?
To reduce the need for on the ground coverage, some investment managers use third party sources (usually their execution partners) for sell side research on both company and macro views. This has meant that for global equity managers, you could base your entire investment team in one location, fly them in and out to do research and then fill in the gaps from your execution partners research database. Some surveys by global consulting firms of global fund managers have shown a forecast decrease in research spend from 10%-30% and in some cases up to 50%. But if the total cost hasn’t changed, why decrease the research spend?
Note that by having research and execution bundled, this total execution cost is passed onto investors. Once unbundled, the research cost element needs to be either absorbed by the investment manager or recovered by increasing management fees to underlying investors. Which will they choose?
This leads to the China investment discussion. There is a lack of on the ground teams in China to provide deep insights into opportunities. Therefore, the only way you can invest is to allocate to blue chips and/or index constituents with little to no proper insight and visibility. This can be dangerous as changes in fundamentals and the macro environment can lead to unintended consequences for investment managers and their clients. Within the context of Chinese companies, given lower levels of transparency and visibility it is critical to have an on the ground presence.
Even if you start building out a team on the ground, it takes time to build relationships (which we all accept to be critical in succeeding in China) and coverage across all industries. This then creates a lag on your ability to invest effectively in China.
We already have this as key criterion for Australian equities yes? I always use the example, regardless of the quality of manager, that if I were to propose that there was an excellent value based Australian equities manager based in Hong Kong, the first question everyone would ask and rightly so is, “what genuine on the ground insights do you have if you aren’t based here?”
In recent years, there have been studies done on active developed market equity managers and their ability to outperform their respective benchmarks. Most of these studies have shown that the average manager has not been able to. In our opinion, one reason for this is not for a lack of trying on behalf of managers, but more so of a reflection of the level of efficiency in developed markets. It’s simply harder to uncover gems when information is so readily available and transparent. In China, on the other hand, the market has shown that over the last decade the average return of active A-share managers have outperformed the benchmark vis a vis CSI300 (90 managers in total). Why?
The exact opposite to developed markets where information is harder to come by and market inefficiency reigns.
Going forward, you will have China in your portfolio whether you like it or not, but you should be asking the manager:
What is your approach to investing in China?
How does this approach differ from how you handle developed markets?
What on the ground presence do you have to navigate inefficient markets?
Jonathan Wu is executive director and chief investment specialist at Premium China Funds Management.