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China has been rapidly opening up its capital market over the past few years, improving access of foreign investors to Chinese securities. In the past, foreign investors could only gain access to China market through the H shares and Red Chips listed in Hong Kong. More recently, with the introduction of the Qualified Foreign Institutional Investor (QFII) system, foreign investors can begin to invest directly in its domestic A-share market.

Long considered the poor younger cousins to Hong Kong's mighty market, China's mainland markets, Shanghai and Shenzhen, are coming of age. A period of restructuring and regulation tightening, designed to raise the level of institutional governance and corporate management, has created a heightened level of investor confidence.

The results have been striking. In the past year alone, the Shanghai index rose 130% and Shenzhen was up 96%. However the recent market correction, although welcomed by professional investors, has tested the confidence of those unused to the gyrations of emerging markets. Most analysts see this as proof of what sophisticated investors already know to be true: that opportunity rarely comes without risk.

 

Mitigating risk

The key to mitigating this risk and optimising the opportunity is to focus on quality investments, says David MacKenzie, product manager with international asset management company Schroders. "Our strategy is to look for companies where strong management can drive long-term growth, rather than focusing on momentum stocks with short-term price gains," explains MacKenzie. "The Shanghai market, for example, is characterised by a mixed bag of 1,300 companies, some with higher levels of corporate governance and quality management, many without," he adds.

But this is changing quickly. While current research identifies only 200 quality players among the 1,300 listed companies, Schroders believes there is untapped potential among the remaining 1,100. "Management is changing and there are better aligned incentive structures in these companies," MacKenzie points out. "For us this spells opportunity. As an active manager, there is a lot of potential for upside if you can identify those winners before the market does."

 

Foreign investment still limited, but set to grow

However, one of the major issues remains the limited access to China's mainland markets, which is all but closed to foreign direct investors. The few funds available are not the typical open funds with which retail investors are familiar and China has capped the amount of money foreigners can invest. The upshot is that few funds exist and that those that do are largely fully subscribed and often closed to new investors.

In a bid to up foreign participation, the mainland government has introduced QFII licences, which have been awarded to a limited number of international fund management houses.

In late 2006, Schroders received its QFII licence allowing it to invest a maximum of $200m in Shanghai and Shenzhen's A-share market.

In response to strong demand from clients, Schroders launched its first equity fund focused exclusively on the domestic A-share market. The fund, advised by Schroders joint venture partner in China, Bank of Communications Schroder Fund Management, will not be available to the retail public but is limited to a select group of professional investors.

The key to successfully building client value in a fund like this comes from the local market connection. MacKenzie says: "The A share market still lacks the transparency and research of more developed indices, but our local on the ground research capabilities through our joint venture, gives us a clear head start in identifying the best companies."

 

Renminbi appreciation and increased liquidity set to support funds

A share fund, in which underlying investments are largely denominated in RMB, also offers exposure to potential currency appreciation against the US dollar. "Given the large trade surplus, and increased political pressure from major trading partners, the RMB is widely expected to appreciate against the US dollar in the coming years," says MacKenzie.

MacKenzie concedes that transactions are still sluggish as investors await a wider RMB floating band, but says that the forward market is developed and that Schroders anticipates gradual appreciation over the coming years.

Schroders is also bullish on the effect of increased interest and liquidity in the A-share market. "Deposit growth is strong in mainland China and will provide additional support for the stock markets as investors seek alternative means to grow wealth outside of bank deposits," explains MacKenzie. "We're already seeing a strong increase in the number of new retail security accounts and the number of foreign institutions applying for QFII licenses is growing steadily."

"Ultimately investors who are looking at high growth markets understand the level of volatility involved. The best way to manage volatility is to work with a fund manager with a proven China track record, an experienced on the ground research team, a disciplined investment process and, of course, rigorous risk management," says MacKenzie.

 

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