Plotting a path into Chinese equity markets

Chinese equities offer a cheap way to gain exposure to the world’s second largest economy and by far the fastest growing economy in the top 10.

Last year, China’s GDP was larger than that of France, Germany and the UK put together, and around that of Brazil, Mexico, Russia and India combined. The Chinese economy grew faster last year than any other in the top 10. The recent underperformance of Chinese equities against nearly all other equity markets has led to appealing levels of valuations that could potentially provide investors with an attractive entry point.

There are many reasons that could explain the underperformance and current valuation levels of the Chinese equity market. I disagree with most of them, but I would rather not focus on these issues for now. Instead, I would like to highlight how challenging it can be to find a way to get exposure to Chinese equities once one has decided to do so.

A potential investor will have first to define what exactly is meant by Chinese equities from a geographical standpoint. Do we want exposure via Chinese companies only? Do we want to extend the opportunity set to “Greater China” and include Taiwan, Macau and Hong Kong?

The decision on what regions to include will have repercussions on the type of instruments available for investment. There is a vast choice of share types and classes available to investors. At one end, there is a large number of ‘A-shares’, issued by domestic companies in the People’s Republic but still relatively hard to access by foreign investors. At the other is the somewhat limited number of more liquid and easily investible ADRs (American depositary receipts) listed on US exchanges.

As we run multi-manager portfolios, we will also need to select a few managers to allocate to. This leads to the last but by no means the easiest challenge faced by potential investors in China: the choice between domestic investment managers and foreign ones.

Having met many Chinese equity managers over the last decade, some based in mainland China, some in Hong Kong and Singapore and quite a few with a Western base, we have come to the conclusion that there is no obvious information advantage between the domestic (ie mainland-based) and other managers. Domestic shops may have a slight edge – and will certainly claim that they do – but foreign managers are usually very well resourced and have local analysts as well. The main difference resides in the investment approach. 

Foreign-based investors tend to adopt a buy and hold investment approach focusing on industry leaders and with a propensity to favour transparent and accessible management teams. Their incentive structure is usually very similar to that of fund managers investing in other parts of the world with one, three and five years as the most commonly used time periods to assess performance. This results in strategies with relatively low turnover.

They are usually able to describe their process in an articulate manner and happy to provide all the information needed to conduct due diligence. Because of the limited access to A-shares by foreign investors, they will usually invest mostly in H-shares and ADRs and may miss out on some of the fabulous growth opportunities available in the mainland markets.

In the People’s Republic, the incentive structure for investment managers has a much shorter horizon. A lot of the managers we’ve seen are paid quarterly bonuses according to their performance over the preceding three months. This leads to a very different investment approach. Portfolio turnovers of more than 400 per cent a year are quite common. This also leads to some questionable investment practices. Two fund groups we have met admitted they frequently invest in stocks held by their peers using their proprietary book in order to dump the positions to depress the prices and hurt their peers’ performance just in time for the quarter-end rankings. 

Domestic managers tend to be reluctant to share information on either their processes or their holdings and also tend to want to impose a fee structure which is a bit too aggressive compared to what we are used to paying.

The domestic investment management industry has only been around for 10 to 15 years and is still very young but there is a huge pool of talent in mainland China. And their passion and belief is second to none. We met a manager last year who was so excited about the cheapness of the Chinese market that he sold his property in the mainland, remortgaged his Hong Kong property and immediately put all the money into the equity market.

Choosing a way to invest in China can be even trickier than finding the right time to do so. We have found that getting exposure to Hong Kong-based managers could give us the best of both worlds. Most have been around for quite a while and are well equipped to deal with our due diligence requirements and usually have a very strong analytical presence in China.   

François Zagamé, portfolio manager multi-asset, Old Mutual Global Investors