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Acadian is increasingly being asked about the potential benefits of a low-volatility investing approach to China A-shares, reflecting interest in accessing that market with a measure of drawdown protection. In this note, we demonstrate that the mispricing of risk is evident in China A-shares, much as it is in other markets around the world. We examine whether any distinctive characteristics of low-risk Chinese stocks differentiate low-volatility investing in A-shares from elsewhere in emerging markets (EM). We also provide a sense of the potential for risk reduction in China A.
In broad strokes, the risk mispricing in China A-shares looks similar to what we see in other equity markets around the world. Figure 1 shows that low-beta China A stocks have outperformed in absolute terms over the past 10 years. Figure 2 demonstrates the phenomenon on a risk-adjusted basis: A-shares in the lowest beta quintile realize a large positive CAPM alpha, on average, while average alphas for stocks in all higher-beta quintiles are negative. In other words, lower-beta stocks tend to earn higher returns and higher-beta stocks tend to earn lower returns than their risk profiles would suggest. This pattern is economically large in magnitude and monotonic.
As in other markets, we believe that the phenomenon exists because higher-risk stocks tend to be overpriced due to irrational demand from naïve investors. We would expect that phenomenon to be particularly acute in a retail-driven market such as China A.1
There are two striking differences between low-risk stocks in the A-shares market and elsewhere in EM. One is that they have distinctive market capitalization characteristics. In Figure 3, the left set of boxplots shows that among China A-shares, the largest stocks have the lowest betas to the A-shares index, while betas in the smallest two capitalization quintiles tend to be well above one. This isn’t the case across other emerging markets, as shown in the right-hand set of boxplots. In EM ex-China A, betas are lowest among small-cap stocks. Figure 3 also shows that betas among China A large-caps are highly dispersed, a further indication of their attractiveness for low-vol stock selection. As a result of the distinctive relationship between market capitalization and beta among China A-shares, China A low-volatility portfolios are likely to hold larger-capitalization stocks than investors are used to seeing in other EM contexts.
A second differentiating characteristic of China A low-volatility stocks is state ownership. While state ownership is a significant theme in EM as a whole, it’s particularly prominent in China A, a point that we discussed in-depth in “State-Owned Enterprises – Buyer Beware?”2 Nearly half of China A companies have state-ownership exceeding 20%, and Chinese state- owned enterprises (SOEs) account for almost all of the substantial recent growth in SOE weighting within the Fortune Global 500.
Nevertheless, we are optimistic about the prospect of building low-risk A-shares portfolios that don’t have unusual degrees of state ownership. The reason for this is that we find no relationship between state ownership and beta among China A-shares. We demonstrate this in Figure 4, which shows variation in both beta and state ownership across industry groups. While the two lowest-beta industries, banks and utilities, are indeed characterized by high degrees of state ownership, there are many low-beta sectors where state ownership is quite low, such as healthcare, food, and services.
Further, if we subdivide stocks in the low- and high-beta quintiles from Figure 2 by state ownership, we find that differences in alphas and betas between SOEs and non-SOEs are not statistically significant.
In sum, despite the relative prominence of SOEs in China compared to the rest of EM, we don’t believe that state ownership should drive low-volatility outcomes in the A-shares market. We do believe that state ownership has potential to help forecast returns, however, and we incorporate it into our stock-selection model.
To provide a sense of the risk-reduction potential in China A-shares, we examine the historical behavior of a hypothetical “plain vanilla” minimum variance strategy. It targets MSCI China A3 as the benchmark, sources stocks from an investable universe (market capitalization greater than USD 100MM), and maximizes risk reduction based on Acadian’s proprietary, dedicated China A risk forecasting model. This portfolio is fully invested, long-only, and rebalanced monthly. We cap stock-level active overweights at 3%, a typical plain-vanilla construction approach.
Figure 5 presents the hypothetical performance of such a portfolio from January 2007 – July 2018. This demonstrates material positive active returns, along with substantial benchmark-relative reductions in beta and total volatility (approximately 15% and 11%, respectively). For investors familiar with other EM contexts, that risk reduction may seem modest. Keep in mind, however, that in the China A context, we’re forgoing country diversification, which has a material beta-reduction benefit in portfolios that span EM.
The year-by-year performance breakout in Figure 6 also demonstrates the potential drawdown protection afforded by a low-volatility approach. For example, during the China A selloff from June 2015 to February 2016, when the benchmark returned -44%, the hypothetical minimum variance portfolio experienced a materially smaller loss of -35.4% (i.e., an active return of +8.6%). A tradeoff of this downside protection is expected underperformance during some strong rallies, as can be seen in 2009 and 2014.
Growing interest in applying low-volatility investing to China A-shares reflects both the increasing prominence of the market and its continued volatility. Evidence that risk mispricing manifests in China A-shares is supported by the behavior of a hypothetical minimum variance portfolio. Investors should expect that characteristics of low-volatility China A portfolios will differ from those in other markets. For one thing, the level of risk reduction is likely to be lower than that seen in broader low-volatility portfolios that benefit from country diversification. Nevertheless, hypothetical China A minimum variance portfolios exhibit reduced risk and smaller drawdowns, suggesting promise for low-volatility investing in China A-shares.
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