Table of contents
January 2018
For decades, China has been slowly opening its economy and capital markets to the rest of the world. Following the death of Mao Zedong in 1976, the earliest reforms came under the leadership of Deng Xiaoping in the agricultural sector and were later followed by the adoption of joint stock corporations and limited liability entities in the late 1980s. The 1990s brought the opening of trade and establishment of capital markets, specifically the establishment of the Shanghai and Shenzhen stock exchanges. At the time, these nascent exchanges served an economy that reflected 3% of global GDP (versus approximately 15% today in nominal or current price terms).
Since then, China has experienced tremendous economic growth, having become the world’s second-largest economy by nominal GDP. Today, China is the leading contributor to global growth, outpacing the U.S. and contrasting sharply with its prior modest contribution, as seen in Figure 1.
This growth has been largely the result of a managed liberalization, progressing away from an agricultural economy to a manufacturing-based one—and, more recently, toward information technology, professional services, and consumer-driven activity. Today, China has emerged as a middle-income level country with novel challenges for sustained growth.
To promote further productivity gains, the Central Committee of the Communist Party of China convened in 2013 to establish a roadmap for continued growth; this plan included a focus on further liberalization of the financial system and broadening foreign investment and competition. This objective is being realized as the local capital market is now accessible to foreign investors through the establishment of several increasingly well-known programs including the Qualified Foreign Institutional Investor (QFII) and Renminbi Qualified Foreign Institutional Investor (RQFII) programs, and the Hong Kong Stock Connect platform (see appendix for more details on these programs).
China’s equity market is comprised of exchanges in Shanghai and Shenzhen and a variety of share classes. Until now, foreign investors’ means to access the Chinese market has been primarily through a small set of overseas listings, primarily H-shares. A-shares have been largely reserved for domestic investors, with foreign access emerging only through the licensing framework of the QFII/RQFII programs, and more recently through the less-restricted Shanghai and Shenzhen Stock Connect mechanisms.
Foreign access to the A-shares market opens up an enormous opportunity set. With over 3,500 stocks traded and $8.5T in market capitalization, the A-shares universe represents the second largest equity market globally. In terms of listings and market cap it trails only the U.S. and exceeds that of Japan.
Even investors who are well-versed in China’s economic development may not be aware that the A-shares market includes some of the largest and most innovative companies in the world. For example:1
The A-shares market is not only broad but also exceedingly liquid, featuring some of the tightest bid/ask spreads in global equity markets (approximately half of median U.S. bid/ask spread2), lowest median cost to trade 5% ADV, and median average daily trading volume that stands far above any other market. In Figure 2 we offer a comparison of various countries’ ratio of average daily traded volume to their respective market cap for the 12 months ending 11/30/2017.
A-shares also represent a much larger and more diverse market than what H-shares have provided to foreigners. A-shares have more balanced sector representation than H-shares, which are dominated by financials and IT stocks. Figure 3 shows A-shares better distribution of exposures across commodities, consumer, financials, industrials, and IT.
MSCI’s initial inclusion of A-shares into its benchmarks will reflect only a small slice of the broad A-shares market. In June 2017, MSCI announced that 222 of the approximate 3,500 companies in the share class will be part of the initial inclusion that will take place in two phases in 2018. These stocks will initially comprise 0.73% of the MSCI EM index weight by August 2018. This modest initial weight reflects several factors including foreign ownership limits (currently at 30% for most A-share companies) and free float adjustments, as well as concerns about restrictive exchange practices associated with settlements, daily trade limits, and suspensions. As these issues are resolved, we believe that China will grow to represent a much larger portion of MSCI’s Emerging Market Index—as much as 40.8%, nearly half of which would be A-shares.3
Thoughtful quantitative investment processes have the potential to thrive in less-efficient markets. The China A-shares market, dominated by domestic retail investors, is rife with inefficiency. Retail participation in the A-shares market represents approximately 80% of daily trading, contrasted with institutional investors who represent the majority of participation in H-shares (30% retail).4 Further, the average local manager has only 2.6 years of experience.5
We are able to observe empirical evidence of this inefficiency. As shown in Figure 4, payoffs to factors such as value, quality, and growth over an extended period appear to be robust. Among our China A-shares universe, quartile returns reflect a market that typically rewards strong fundamentals.
Systematic, fundamentally driven investing requires data. As the Chinese equity market has developed over the past two decades, so too has data availability, which provides information on various metrics such as price, valuation, and earnings. In addition to price and fundamental data, analyst coverage has grown from near zero in 2003 to over 2,000 A-shares companies currently, as shown in Figure 5. Perhaps surprising to investors new to the market, we have coverage and can apply our fundamentally focused alpha model to the overwhelming majority of the approximately 3,500 A-shares listed companies.
Investing in the Chinese market presents unique risks, which help to explain MSCI’s lengthy process for index inclusion. With a dominant retail investor base, A-shares have historically been prone to higher volatility. As described above, the dominance of retail investing is most likely a factor that contributes to higher volatility in the A-shares market, with annualized five-year risk (standard deviation of annual returns) at 27.2% vs. 21.3% for H-shares. Likewise, a time series of one-year rolling standard deviation of returns shows a market that is more volatile than MSCI Emerging Markets and World indices.
One element of the Chinese market that remains a concern for investors is the pattern of trading suspensions that have been more prevalent than in other markets. This consideration was noted by MSCI as they deliberated over A-shares inclusion. While liquidity is robust, investors may question whether it will be there when needed given the number and length of suspensions. Suspensions in China may occur for many reasons, including but not limited to: asset reorganization or restructuring, irregular trading activity, or an attempt to avert drastic price swings in periods of heightened volatility. While we believe that accounting for suspended securities in the portfolio construction process may mitigate some risk, this concern nevertheless merits consideration; however, we believe that the environment is improving, and will continue to do so going forward, as inferred from the downtrend noted in Figure 6. Furthermore, we believe a systematic investment process that continuously incorporates prudent risk controls in conjunction with alpha opportunities is the best approach to allocating in any new class of equities.
The China A-shares market presents an opportunity to participate in one of the world’s most expansive and liquid equity markets, underpinned by a major economy whose growth continues to outpace most others. We acknowledge that there is continued work for Chinese regulators, index providers, and investors alike as one of the largest yet least accessible components of the market continues to mature. We are encouraged that the availability of company data has largely accompanied the impressive growth of this market over the past two decades and that the commitment to reform exhibited by the Chinese government has allowed for continually improving access among foreign investors.
As this market expands, Acadian believes there is a robust investment opportunity for active systematic stock pickers. The A-shares universe materially broadens an investor’s opportunity set. Further, given the market inefficiency, our disciplined and structured approach is particularly well suited to invest in this unique share class of equities.
Appendix
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