Every investor is thinking about China, but most don’t have a specific plan for it. The Asian giant is already a dominant power in its region, in emerging markets and in the world. Recent equity weakness doesn’t change the long-term view: The China opportunity will continue to grow.
Yet despite China’s potential, more than eight of every 10 institutional investors don’t yet have a plan for incorporating China in their portfolios, based on a recent survey we conducted of global institutional investors. In fact, one third of institutions plan to leave the decision to their investment managers.
One thing that’s clear is that institutions want an active manager in charge of their China investments. Of those we polled, 86% supported active investing. That makes sense to us, because active management can be especially effective in China.
But what about the approach to integrating China in a portfolio? There are two basic options: The first is to access China as part of a global or emerging-market (EM) strategy. The other is to add a dedicated mandate to China stocks or bonds. Is there one right way to invest in China? Here’s our perspective.
Most Investors Are Underweight China Equity
Based on our experience and conversations with clients, most institutions aren’t ready to make a China-only equity allocation. Almost 80% of the institutions we surveyed are accessing China through a global or EM strategy. Unfortunately, this may not be the best approach, because most benchmarks are substantially underweight China.
For example, China currently represents 34% of the MSCI Emerging Markets Index, based on market capitalization—but it would be more than half if weighted by gross domestic product (GDP), and even more if weighted by GDP growth. What’s more, China’s index allocation is largely Hong Kong–listed companies (H-shares) and those listed in other markets like the US, as opposed to A-shares, which offer a much broader opportunity set.
A-Shares Expand China Equity Alpha Potential
MSCI has only recently started adding China A-shares, which currently represent only 0.4% of the MSCI EM. This share should increase to about 0.8% in September—still a small fraction of what it would be if MSCI included A-shares at their full market weight.
The A-share market—“the onshore market”—offers many opportunities unavailable through offshore-listed companies. For example, the onshore market is full of growing healthcare companies. Many technology firms from the Shenzhen market are inaccessible offshore. The market also provides access to China’s explosive consumer growth and local brands popular with the growing middle class.
A-shares also boost diversification. Over the five years ended March 31, 2018, the correlation between the MSCI China A Index and MSCI World Index was only 0.30. In contrast, the correlation between the S&P 500 Index and MSCI World was 0.95, and between the MSCI EM and MSCI World, 0.75.
As we see it, the market is ripe with alpha potential. It’s relatively inefficient and has many individual retail investors who often lack critical information about company fundamentals, and information flow is much less than perfect. Over the long run, prices ultimately align with fundamentals, but short-term inefficiencies can decouple the two, creating opportunities.
Getting Ahead of the Growing China Presence
Investors who want more control over their China allocation and more exposure to the opportunity set should consider adding a dedicated strategy. This would align their portfolios more closely with China’s true opportunity set and help get their China equity allocation ahead of the likely growing index weight in EM and global benchmarks.
MSCI hasn’t specified a timeline for further increasing the A-share weight, but it’s highly likely to happen in the coming years. At full inclusion, Chinese stocks—including A-shares and other share classes—would likely comprise more than 40% of the MSCI EM.
Given the amount of capital that tracks the index—both actively and passively—this would unleash significant inflows. In the meantime, investors who simply wait for full inclusion would be increasingly underweight this compelling opportunity, because not all global or EM managers have the research scope to cover so many issuers. There are more stocks listed in the China A-share market than in either the Nasdaq Stock Market or New York Stock Exchange.
Two Approaches to Stand-Alone Equity Strategies
A dedicated China strategy could take one of two forms—either a dedicated A-share strategy or a more comprehensive China strategy that combines onshore-listed A-shares with offshore-listed H-shares in Hong Kong or other markets.
Some plans have added, or are considering adding, a stand-alone China A-share strategy—although these plans are still a minority. Others are considering a more comprehensive approach that allows managers to invest in Chinese companies regardless of where they’re listed. Both approaches have merit.
Since most investors already have H-share exposure through their global or EM portfolios, complementing it with a dedicated A-share strategy makes sense and helps avoid overlap. But as onshore and offshore markets converge, there’s a strong case for a single, comprehensive “All China” strategy that invests across both A- and H-shares. Many companies are listed in both markets, providing arbitrage opportunities. And by shedding the A/H-share distinction and tapping both markets, managers can better focus on the best opportunities.
Adding an All China portfolio could result in some overlap with existing EM mandates, but we believe that this is more than offset by the benefits of an integrated portfolio—and is a better representation of China’s real economy. Of course, investors adding a stand-alone China strategy should consider existing managers’ exposures to ensure that they’re complementing—not just doubling up. This consideration will undoubtedly become more important as China’s weight in EM indices and global markets grows.
Investors may also want to start thinking about their EM portfolio in two parts: All China and EM ex-China. We believe that the market will likely evolve along these lines in the coming years as China’s weight in the EM universe continues to grow.
Regardless of which approach investors choose, we see a compelling case for getting ahead of the curve and increasing exposure to Chinese equities today.
Enormous Potential in China’s Onshore Bond Market
China’s $11 trillion bond market is the world’s third largest—and it’s only recently starting to open to outside investment. There’s no doubt that the onshore China bond market offers tremendous opportunity for global investors.
China sovereign bonds yield more than many developed-market sovereign bonds, with a low correlation to major asset classes. And they behave more defensively in market sell-offs: In risk-off periods since 2005, the S&P 500 fell by an average of 2.5%. The Bloomberg Barclays Global Treasury Index (USD Hedged) rose by 1.8% and the Bloomberg Barclays China Treasury Index (USD Hedged) rose by 3.1%.
Foreign participation in the market is low right now. At the end of 2017, outside investors owned only 2% of the onshore China bond market. However, this share is set to rise as China becomes a greater share of EM and global bond indices. For example, if the J.P. Morgan, Citigroup and Bloomberg Barclays indices move to their potential China weightings, it would represent an inflow of nearly $300 billion. That inflow alone represents a tremendous opportunity for investors.
In many ways, China’s bond markets—rated A+ by Standard & Poor’s—behave more like those of developed markets than those of emerging markets, with government and policy-bank bonds playing a role as a defensive asset class. Many other EM government bonds, in contrast, often play more of a growth role, and they offer little or no protection in an equity downturn.
Assessing the Risks in China Fixed Income
However, there are potential risks alongside the opportunity. China’s bond market isn’t as deep or liquid as those of the US, Europe and UK. The lack of liquidity, continued capital controls and still-developing access routes make it hard to argue that China’s government bonds should be considered a true core developed market.
Until China’s capital account is fully open, our view is that some caution is warranted. From our perspective, most investors should consider accessing China as part of an active global or EM strategy, allowing investment managers with the required China fixed-income expertise to manage the investment. Over time, these allocations will become larger and more permanent as the bonds are included in major indices.
Some Investors Want More China Bond Exposure
Some fixed-income investors, however, may be interested in having more exposure to China than global or EM bond indices currently call for. In these cases, we think a dedicated China bond portfolio with a diversified structure is worth considering.
We think adding credit exposure with a barbell structure, including interest-rate-sensitive bonds, makes sense. There’s opportunity in credit beyond cyclical stress from interest-rate hikes, but credit markets are also less transparent than government bond markets—this requires in-depth knowledge of local bond markets and credit analysis.
On the interest-rate side of that barbell are Chinese government bonds and policy-bank bonds. The bonds issued by the largest policy bank, China Development Bank, are more liquid than China’s government bonds. Policy-bank bonds trade at a higher yield than government bonds, largely because of differences in their tax treatment. Even taking the tax into account, we see good value in China’s policy-bank bonds in the current environment.
In the years ahead, the share of Chinese bonds in global and EM indices will continue to grow, and so will the allocations required for portfolios to keep pace. Currently, we see strong reasons for active global and EM bond managers to start increasing their allocations to China government bonds.
For larger, more permanent allocations to be considered, we still point to the relaxation of capital controls as the biggest piece of the puzzle for fixed-income markets. If this relaxation continues, and if it’s accompanied by continued reforms, it would increase our conviction in suggesting even higher levels of exposure to China.
There’s no doubt that China’s presence in the world’s capital markets will continue to grow, with major implications for portfolio construction and available opportunities. Yet more than three quarters of institutional investors don’t have a specific China plan yet. We think it’s time for those conversations to start.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.