Behind Chinese walls
Liyu Zeng and Priscilla Luk analyse the challenges in designing a benchmark to measure the performance of both offshore and onshore listed companies
There is little doubt regarding the growing importance of China to the global economy. Its nominal GDP is estimated to have reached $11.4 trn (€10trn) in 2015, representing 15.5% of the world economy, second only to the US.
As of the end of 2015, the size of equity and bond markets in China had reached RMB53.1trn (€7.2trn) and RMB36.8trn respectively, with assets under management of RMB8.4trn in its fund management industry. With sustained economic growth and an isolated environment owing to the restrictions on capital flows, Chinese financial assets tend to have low correlation with other financial assets. This makes them potential diversification tools and an essential part of long-term investment strategies for investors.
The Chinese government has sought to stimulate the economy since the 1980s. Adopting approaches including privatisation of government-controlled enterprises to foster competition; opening up markets; establishing equity markets to finance the growth of the private sector and to support fiscal spending; the introduction of institutional investors into the market; and the initiation of the mutual fund and exchange traded fund markets.
China’s onshore and offshore listing markets were traditionally segmented owing to foreign exchange controls. Despite most Chinese corporations being listed on domestic exchanges, the number and aggregated market cap of China’s offshore-listed companies has been increasing over the past 15 years, and they have maintained about 30% of the market share of all Chinese listings by market cap since 2007. By the end of 2015, there were more than 1,200 offshore-listed Chinese companies with an aggregated market capitalisation of about $2.7trn.
Of these offshore listings, many are domestic or global leaders in their respective industries, such as China Mobile, the consumer electronics retailer GOME, and discount computer manufacturer Lenovo. There are also consumer producers that offer well-known brands, such as Belle, Want Want, Mengniu, luxury car dealer Brilliance China Automotive, and education service provider New Oriental. Internet retailers and service providers such as Tencent, Alibaba and Baidu also contribute towards the offshore listing market. It is worth noting that these industry leaders are only investable through offshore listings.
For the domestic market, financials, industrials and consumer discretionary are the largest sectors by capitalisation. The largest companies are dominated by giant financial and energy names including Petrochina, Industrial and Commercial Bank of China, China Life Insurance, China Petrochem and China Merchants Bank. There are also well known domestic consumer names such as Kweichow Moutai, SAIC Motor, Midea and BYD. Compared with the offshore market, the domestic market has a higher concentration in the financials and industrials sectors, and a lower weighting to information technology (IT). As of 2015, there are 1,018 and 1,746 companies listed on the Shanghai and Shenzhen Stock Exchanges with market capitalisations of RMB29.5trn and RMB23.6trn respectively.
Foreign investment in China is restricted by foreign exchange controls, but the government has been introducing bilateral channels to deepen capital flows. These initiatives include Qualified Foreign Institutional Investor (QFII), Renminbi Qualified Foreign Institutional Investor (RQFII), Renminbi Qualified Foreign Institutional Investor (RQFII), Shanghai-Hong Kong Stock Connect and the Mutual Recognition of Funds (MRF).
As capital deepens in the Chinese market, the demand for benchmarks and investment tools integrating onshore and offshore listings is increasing. Such demand has seen a new market for benchmarks designed to offer more complete coverage of Chinese companies listed both on and offshore.
Adopting a ‘total China’ approach allows investors to track both onshore and offshore listed companies, and represents a real and complete representation of the market. Because of this, we expect the approach to become the preeminent method of measuring China’s economy.
Achieving sector composition in line with the broader market during stock selection is a key problem in Chinese index composition. Avoiding sector bias and concentration risk is vital in building benchmarks that are reflective of their respective regions.
For example, the IT sector, which comprises less than 8% of onshore indices, is under-represented and should be closer to 16% when considering total China principles. On the other hand, industrials and materials, are under-represented in the offshore China indices as most companies from these sectors are only listed onshore. These account for 15.7% of the onshore index which we think should be less than 9% when taking a total China view.
Data shows that a combination of onshore and offshore stocks could result in much lower concentration risk to the financials sector than most current onshore and offshore China indices. The financials sector dominates 37%-73% in the onshore and offshore. Such concentration risks should be considered in index design.
As China is the world’s second largest economy, experiencing capital market growth, equities could remain an essential part of long-term investment strategies. With the introduction of various domestic and foreign investment plans (QFII, QDII, RQFII, Stock Connect, and MRF) that broaden capital flows between domestic and international markets, the demand for benchmarks that integrate the Chinese on and offshore listings will continue to rise.
Indices make up the backbone of performance tracking, and their providers have a role in compiling products which reflect any given investment region, not only to help managers assess their own performance, but to help investors better understand their investments.
Liyu Zeng is director, global research and design, and Priscilla Luk is senior director, global research and design, at S&P Dow Jones Indices