As investors, we scour markets to find under researched and underutilised opportunities in a constant hunt for alpha. This can lead us to niche markets, strategies and sectors.
Yet, occasionally these opportunities are staring us in the face…
The rise of China has been difficult to ignore, with its rapid ascent to global powerhouse and accumulation of vast wealth. With a massive population, rapid industrialisation and economic liberalisation, it is unsurprising it now has one of the world’s largest stock markets.
The Chinese onshore market, made up of stocks traded on the Shanghai and Shenzhen stock exchanges (known as A-Shares), is the second biggest equity market globally, both in number of stocks traded and market capitalisation. Beaten only by the US.
Unlike other large stock exchanges, there is a lot of evidence it is under researched and underutilised, thus offering great potential for active management.
Ownership of stocks within developed markets is dominated by institutional investors – full time investors who (should) do nothing all day but research, buy and sell stocks. Whereas in China, domestic retail investors (trading on their phones on the morning commute!) dominate China A-Shares (due to historic capital controls). In fact, foreign investors make up only around 2% of the market.
Some might question whether institutional money can create truly efficient markets, but it seems unlikely that these part-time trading retail investors are better at it. You can begin to see this when looking at some simple characteristics of the A-Shares market:
It’s heavily traded
The ratio of average daily trading volume to market capitalisation is significantly larger than the US and over double that of Japan.
There’s high dispersion of returns
The average standard deviation of the largest 300 China A-Shares’ monthly returns is nearly twice that of the S&P 500.
Over the last 10 years, MSCI China A Onshore had a volatility of 28%, whereas MSCI Emerging Markets was 22% and MSCI World just 16%.
China’s inefficient market is a dream for active managers. We believe that a clear investment philosophy, backed by empirical evidence, implemented using a robust process has great potential for alpha generation. It’s not uncommon for funds to generate levels of alpha that would be considered extraordinary in other markets. This, combined with back tests of relatively simple systematic strategies, suggest that A-Share market participants are susceptible to the same behavioural errors and emotions that drive the rest of the world’s financial markets. There will of course be nuances within the A-share market, but the key tenets that make successful active managers appear unchanged.
As China opens further to foreign investors and with MSCI beginning to include the A-Shares in relevant global and regional indices, it is only a matter of time until the market comprises a significant portion of every investor’s equity portfolio. Rather than waiting for this to happen, Nick Samuels, Oliver Wayne and myself have already done a lot of work in this area to understand what it takes to be successful in China.
The Redington Manager Research team will be scouring the market in September visiting Hong Kong, Shanghai and Beijing – we’re looking forward to finding under researched and underutilised ideas that will help with our mission of making 100 million people financially secure. We’ll be reporting back on our findings later in the month.
Sources: Acadian, Blackrock, MSCI, Wellington