Alpha abounds in China despite significant headwinds
China continues to open up to foreign investors and although stockpickers have faced a tough time outperforming benchmarks of late, the right managers can add alpha
Chinese equities offer a highly diverse opportunity set for active managers to derive alpha against their selected index.
The universe of eligible companies is in the thousands and the asset class is evolving rapidly. Chinese authorities are liberalising financial markets and have made Shanghai-listed A-shares accessible to foreign investors. Index provider MSCI will incorporate Chinese companies listed in the US via ADRs (American Depository Recipt) into the MSCI China index, thus reducing the weight of ‘old economy’ State Owned Enterprise (SOE) stalwarts such as banks and telecoms in favour of ‘new economy’ technology and consumer-focused companies.
MSCI may even include A-shares in their emerging markets index within the next few years. Add to the mix the ongoing SOE reforms, designed to make companies more efficient, and you have a very exciting backdrop for investing in the region.
Our initial search was in 2013 and the requirement was to select an active manager that we could blend effectively with the Hang Seng China Enterprise (HSCEI) Index. The research team created a universe of some 40 eligible onshore and offshore funds. The analyst leading the search had also visited China and Hong Kong to meet with companies.
The shortlist was narrowed down to three managers with very different approaches to portfolio construction. The common thread was consistency of returns, significant assets in the region and deep analytical resource. All were based in Hong Kong and Mike Shiao’s Invesco Perpetual Hong Kong & China Fund was selected.
Our Chinese equity strategy evolved in 2014 and we conducted a new search through Morningstar. We initiated a fresh series of interviews and ran several draft model portfolio iterations with the underlying stock holdings from each manager through style research as a composite Chinese equity basket. We also examined various weightings between managers looking at a range of outputs including ex-ante tracking errors, model betas, market cap distributions, style output (growth versus value) and liquidity.
Invesco Perpetual Hong Kong & China was retained and the search allowed us to benefit from a recent manager change on the Fidelity China Focus fund, as Jing Ming had moved from BlackRock with a strong value based track-record. We also added a manager with a pronounced mid-cap orientation through Michael Lai’s GAM Star China Equity fund.
The Chinese equity strategy was part of our target return portfolios, which have absolute return objectives. These portfolios utilise third party funds heavily for equity and fixed income exposure, with a derivative overlay applied to hedge out the beta in whole, or in part, in certain markets based on our medium-term outlook for particular asset classes.
This overlay also allows mandates to participate in sophisticated institutional strategies, unavailable to many traditional discretionary managers.
The view in 2013 was that long-term growth could surprise on the upside in China and Chinese equities were particularly unloved trading on single digit forward PE ratios compared to double digit ratios across all other markets. It was acknowledged then that short-term headwinds to this strategy could come from the restructuring that was required to wean this command economy away from credit, and the potential aftershocks from the build-up in non-performing loans post Lehmans.
As the Chinese economy continued to decelerate, we started to see the tentative ripple effects of stress in the ‘shadow banking’ sector with the near default of some structured products. Given that both the HSCEI and Hang Seng Index (HSI) are dominated by banks and property companies, we decided to bed in some protection in 2014. Our 3 per cent weighting evolved into using active managers to derive ‘alpha’, with hedging in place via HSI futures to reduce the beta.
Year to date it has been a challenging time for stockpickers to outperform as each piece of poor economic news sees the market surge on the likelihood that the Chinese authorities will introduce yet another mini-stimulus package.
Despite this headwind to fundamentals, our model has benefited across all three managers but with distinctly different drivers.
Mainland A-shares via Fidelity have benefited both from renewed domestic demand and ease of access to the market for foreigners via the Connect Programme. GAM’s Hong Kong-listed mid and small caps have accelerated as the authorities have allowed mainland investors access to the market for the first time.
The Taiwanese holdings in the Invesco Perpetual fund have also received an uplift, thus helping us overall to outperform against the short index position and post positive attribution from our blended strategy.
Jason Day is Senior Investment Manager at Standard Life Wealth
