A-shares: The best is yet to come
China is a compelling story for investors despite the recent market volatility, argues Charles Salvador. But he warns against short-term thinking and half-hearted approaches
At a glance
• China’s share market is still relatively unknown relative to its large size.
• The recent stock market correction illustrates the need for structural reform
• Much of the recent volatility in markets relates to retail investors with short-term time horizons.
• Despite the short-term volatility the government has made a concerted effort to improve the workings of the stock market.
China is in the news everyday and on the lips of every investor, albeit coverage is often greatly misguided. Even so, China remains little known by most global asset owners. Although it is the world’s second biggest economy, it is vastly under-allocated in most portfolios. Lingering in the shadows of China’s volatility, government interventions, and economic slowdown, capital markets are experiencing a pivotal shift in structure that will fully open access to equities for global investors sooner than most expect.
The Chinese market is much more open to foreign investors than at any time in history. It has a wide range of cross-border platforms that provide easier access to all investor types and strategies. These range from long-term investments by international asset owners to global asset managers manufacturing A-share fund products. But as the availability of Chinese A-share advisory services and products widens, so does the spectrum of their quality, which highlights the need for either a dedicated onshore presence, or local advisers.
A common concern among investors has been the recent volatility in Chinese equities. Institutional investors should remember that volatility has always been a price of admission, but as the other barriers are falling, it has come to the forefront. However, the real opportunities in China lie beyond the headlines.
The old adage of “when America sneezes, the world catches a cold” has become applicable to China, such is its influence on global financial markets. By 2020, most asset owners’ investment portfolios will have exposure to A-shares directly or indirectly. The time frame for future allocations will be largely predicated on the further opening of market access, rather than reduced market volatility.
The August domestic equity correction that followed an even larger rally has illuminated the need for structural reform. Regulators in China never let a good crisis go to waste, and as the world is transfixed by equity market volatility, major market reforms are being enacted which will contribute to the long-term stability of the financial system. Volatility controls, such as internationalising A-shares via the Shanghai-Hong Kong Connect and the imminent launch of the Shenzhen Connect programme, index circuit breakers, and strengthened margin trading policies will encourage steadier trading.
Meanwhile, the government’s reinvigorated focus on structural reforms to state-owned enterprises to improve business efficiency and profitability is taking priority. Even when looking at a shorter time frame, the government has made it clear that it is willing to go to great lengths to halt declines and bring stability back to the markets. So with domestic institutions pricing the worst-case scenario into blue-chip stocks, and regulatory measures effectively placing an implied put option in the market, high-quality listed companies are presenting more attractive long-term opportunities.
The opportunities that China offers have attracted large foreign financial institutions, which gain direct access to domestic capital markets through the Qualified Foreign Institutional Investor (QFII) platform. Asset owners such as Norges Bank and Canada Pension Plan Investment Board have well over $1bn (€880m) in QFII assets. However, the imminent launch of the Shenzhen-Hong Kong Connect programme, to complement the existing Shanghai-Hong Kong Connect, will open the doors for asset owners to gain A-share exposure without the restrictive framework of QFII. In tandem, a Shanghai/Shenzhen-Hong Kong Connect platform will significantly expand the universe of listed companies available to institutional investors, specifically China’s fastest growth companies typically listed on the Shenzhen exchange. It is likely that in the future most global asset owners will primarily use the Connect platform for their equity allocations.
Chinese regulators’ commitment to the further opening of China’s capital market is highly correlated to an A-share reweighting by the indexers. As financial institutions continue to develop their China strategies, it will soon be the focus of index providers MSCI and FTSE Russell, which are both expected to include domestic A-shares in their respective indices between 2016 and 2017. This will provide the most comprehensive foreign benchmark for China investments.
As compelling as the China story appears, it would be naïve to think that it is a riskless trade. China is difficult to understand, more so than most markets. The seesaw of volatility coupled with the surprise government intervention tactics over the past few months showed the value of working with local investment partners closely to manage exogenous risk. Additionally, language, investment culture and information dissemination remain consistent risk factors that most foreign institutions underestimate when developing or implementing their A-share strategy.
For starters, managing onshore risk is a team sport which is best managed by working closely with service providers – custodians, brokers, consultants, and external managers – that have maintained an extensive onshore presence. Even then, expect a bumpy road as the frequent and constant transformations to the capital markets pose challenges for even the most seasoned service providers.
More than 80% of A-share investors are retail investors, a figure that equates to about 200m individuals. As a result, much of the volatility stems from a population of individual investors with short-term investment horizons. On average, individual investors hold mutual funds for less than six months, which puts pressure on domestic fund managers to perform over much shorter intervals compared with global asset managers.
“Investing in A-shares is not for the fainthearted but those investors who understand its benefits and pitfalls should recognise that a concerted effort has to be made when building a long-term strategy that looks well past five years”
To meet the high return demands of retail investors, the 90-plus fund management companies competing for assets under management (estimated at $1.1trn), often evaluate portfolio manager performance on a monthly to quarterly basis. While China works towards a more institutionalised capital market, volatility will remain inevitable. On a positive note, for the long-term institutional investors who look five to 10 years out, the volatility creates opportunities to discover which are the high-quality listed companies.
Investing in A-shares is not for the fainthearted but those investors who understand its benefits and pitfalls should recognise that a concerted effort has to be made when building a long-term strategy that looks well past five years. As China continues to open up to foreign investors, local partners are vital to a successful China strategy. The choice that asset owners face is between finding a high-quality advisory firm to walk them through every aspect, or building a large presence on the ground. A half-hearted or middle-ground approach will not work.
The temptation is to view the recent events with trepidation, but that would be missing the underlying story. The government has overseen 13 years of planned and structural improvements made to China’s financial markets. Short-term equity market volatility will come and go, but make no mistake – there has been no volatility of intent.
Charles Salvador is director, investment solutions, at Z-Ben Advisors