Digital Features

Inside view: What investors are missing without a dedicated China equity allocation

Simon CoxeterWithout dedicated China equity allocations, investors miss an exceptional opportunity to enhance their portfolios’ prospective risk-adjusted returns, and fully capitalize on the diversification and alpha offered by China’s public equity space. Most investors gain equity exposure to China via broad global or emerging market (EM) mandates, with the overwhelming majority of that exposure delivered offshore by multi-national companies listed outside China and Chinese companies listed in the US and Hong Kong. Despite the size of China’s onshore A-share market, which is composed of about 4,000 stocks, and second in market capitalization only to the US equity market, A-shares represent an almost inconsequential weight in many investors’ portfolios and global benchmarks. A-shares amount to less than 1% of the MSCI AC World Index, for example — lower than the individual weights of the few largest US company constituents. The anomaly of this meagre portfolio representation is that China’s A-share market offers the most compelling potential for diversification and alpha across the global equity landscape. Although A-shares have not been as accessible to foreign investors as China’s offshore equities, access has improved over recent years with liberalized Qualified Foreign Investor and Northbound Stock Connect schemes. There is a clear case for more balanced and representative China allocations that incorporate higher strategic A-share exposure than is currently typical within investors’ portfolios. The A-share market is lowly correlated with other markets, partially driven by China’s unique economic, corporate and political backdrop. Relatively insulated from global factors and flows, local market participants own over 90% of the A-share market, contributing to lower correlations. Expanding foreign participation in the A-share market could increase correlations over time, but relatively low correlations would continue to be underpinned by enduring economic, corporate and political asynchrony between China and the rest of the world. High retail participation in the A-share market fuels inefficiencies from which skilled managers can benefit. Although inefficiencies should decline as the market institutionalizes, we expect a favorable environment for years to come, and believe that the A-share market is currently the world’s most attractive liquid source of equity alpha. The A-share market is more volatile than many other markets, and dedicated China equity allocations typically exhibit higher volatility than most other components of a global portfolio, but our view is that this volatility can easily be managed within a total portfolio context. High economic growth is often touted as the primary rationale for China exposure, but the relationship between economic growth and stock returns is noisy and unreliable, particularly over shorter periods. So we only view this as a potential ancillary positive, acknowledging that Chinese companies could benefit from the tailwind of China’s growth. China’s policy agenda is increasingly directed towards domestic consumption, productivity, innovation and higher value-added segments like advanced manufacturing, healthcare and renewable energy. Over coming decades, China’s ascent could propel heterogeneous economic and corporate growth drivers that deserve meaningful representation in portfolios. With escalating prospects of bifurcation between China and the US, and the emergence of more distinct regional blocs, diversified exposure to global growth may only be achievable with a substantial allocation to China’s full onshore and offshore opportunity set. In the absence of a crystal ball, long-term risk management is ultimately supported by balanced exposures to sources of growth, because the future can play out in ways that relegate unbalanced portfolios to the wrong side of history. The A-share market provides access to areas of China’s economy that are not well represented offshore — such as leisure and areas of technology — and deeper pools of companies across market capitalization size bands. As China’s onshore capital markets develop and mature, we expect them to be increasingly important venues for new listings, strengthening the strategic relevance of A-share exposure. The recent wave of regulatory actions in China — which had a pronounced negative impact on key industry concentrations within China’s offshore opportunity set — underlines the need for more diversified exposure via the onshore market, offering greater flexibility to align investments with policymakers’ long-term objectives and manage regulatory risk. While there are risks associated with China, and attention to environmental, social, governance and geopolitical risks is critical, these risks should not preclude higher strategic exposure to China within portfolios. To ensure consideration of these risks, and alignment with investors’ beliefs, active management is vital. Geopolitical risk can affect any market, but is notable with China because politics and foreign policy will feature prominently in the world’s response to its strategic rise. Geopolitical risk actually underpins China’s role in portfolios, as geopolitical shifts could elevate its importance within the investment sphere. To accomplish larger, more balanced China exposure, we have two preferred implementation approaches. One is to complement China exposure within EM equity mandates with a separate A-shares or All-China allocation, with the latter investing across China’s onshore and offshore universe. The other approach is to carve China out of the EM allocation in a structure with separate EM ex-China and All-China allocations. With robust manager selection, investors can identify specialist China managers that are well positioned to exploit alpha opportunities. Genuine diversification and outsized alpha are among the rarest and most valuable characteristics in constructing risk-efficient portfolios, and many investors are missing out on both without dedicated China equity allocations. By Simon Coxeter, growth markets director of strategic research, Mercer © 2021 funds global asia

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