Chinese equities - are investors ignoring a tasty free lunch?

Chinese equity indices have recently outperformed global markets. In addition, Chinese investment managers have continued to outperform their benchmarks during these turbulent markets.

“China has offered material diversification benefits, just as it did from 2007 to 2009,” says Lars Hagenbuch, a consultant at RisCura.

“The low correlation of Chinese equities with other regions is well-documented, and a fundamental reason behind this could be the unique shareholder base that has different motivations to shareholders in other countries, both in developed and emerging markets,” says Hagenbuch.

While foreign ownership of mainland China securities has increased over the last five years, it is still barely above 3% of market cap. The remaining 97% are local shareholders who are largely restricted from investing offshore.

Hagenbuch believes foreign shareholding of Chinese securities will increase over time. However, it depends on many factors such as the pace of reform of Chinese markets, and adoption by global asset owners, index providers and fund managers.

Chinese A-shares are not reliant on the same global flows as other equity markets

“We have noted an almost consistently high, positive relationship between developed markets and emerging markets, whereas the relationship between Chinese A-shares and developed or emerging markets is inconsistent and negative at times,” says Hagenbuch.

Furthermore, the make-up of Chinese shareholders is very different: almost half are retail investors.

“Many local asset managers are still guided by short-term performance,” says Hagenbuch. “This means that prices are driven far more by sentiment and speculation than the underlying fundamentals of companies. This creates a different pattern of returns, with higher volatility.”

The Chinese state attempts to manage all aspects of the local economy

This is a double-edged sword, says Hagenbuch. “Centralised management means that the country can achieve objectives that are nearly impossible in other countries – for example around infrastructure or regulatory changes.

“But policy mistakes do happen and can be costly. The management of financial markets is no exception.”

Just as many of the world’s investment policies are shaped by the US Federal Reserve and the European Central Bank, the Chinese are affected by what their central bank does. Over the last decade, China has implemented a wide range of monetary and fiscal policies in pursuit of a stable economy.

“This has caused shorter and sharper market cycles that can be completely unrelated to what is happening elsewhere in the world,” says Hagenbuch.

“Unconventional measures may also be used, like influencing the activities of state-owned asset managers to prop up stock markets. When mistakes are made, having ‘executive control’ allows the Chinese government to respond to policy mistakes quickly.”

Vast domestic market presents incredible growth opportunities

The Chinese economy, fed by its large population will only become more significant in the long run.

There are more than 5 000 Chinese companies listed on the mainland and internationally that benefit from the country’s huge population, which is well-connected through technology and roads and railways..

Add to this a fast-growing middle class, a steady trend towards urbanisation and, with that, substantial increases in domestic consumption. Many of those 5 000 companies only focus on domestic business and have little exposure to overseas markets. The vast domestic market presents them with incredible growth opportunities.

All this means that China can press ahead independently and impact the world in a way that currently only the US can.

“Every investor seeks diversification and we believe that China has much to offer to improve the risk profile of an equity portfolio,” says Hagenbuch. Ignoring it, or lumping it in with the emerging markets allocation, leaves a tasty free lunch uneaten at the table.

ENDS