This is the first installment in a series of articles on Investing in China A-shares.
Quick and important disclaimer: The analysis and views expressed in this discussion are my own and do not necessarily represent the views of my employer or any organization I am affiliated with. Nothing in this article constitutes investment advice or a recommendation to buy or sell any security.
You are probably under-allocated to China A-shares. This may seem an uninteresting statement at first glance. China A-shares—that is, stocks listed in the Shanghai or Shenzhen Stock Exchanges—make up 0.65% of MSCI ACWI. Even being completely unallocated to China A-shares seems perfectly rational. Why would you expend any mental energies on such a small allocation? By contrast, China ADRs and H-shares, Red Chips, and P Chips (mainland Chinese stocks listed in Hong Kong) make up a bit less than 5% of ACWI. In fact, a single Chinese ADR, Alibaba, has a 0.78% weight in ACWI. Sweden has a 0.93% weight. And yet, I am not writing articles about precisely what allocations to Alibaba or Sweden should be. But there are reasons you should focus more on China A-shares.
The first is that China A-shares has a 20% multiplier applied to its weight in MSCI ACWI. In other words, if it were included at its full float-adjusted market capitalization, its weight would be roughly 5 times higher at 3.25%. There was some sense to this multiplier before as A-shares were less easily accessible and more likely to be suspended from trading. However, because of the Hong Kong Connect Program, China A-shares are easily accessible, far easier than stock markets like India’s, which is included at full weight. Moreover, while stocks can be suspended, the percentage of stocks that are suspended have dropped dramatically and currently stands at about 0.5%.
In other words, if you are allocating similarly to MSCI ACWI or MSCI Emerging Markets, then you are underweight China A-shares relative to its free float market capitalization and for reasons that do not hold particularly well anymore.
But even that 3.25% weight does not do China A-shares justice. China A-shares is the second largest stock market by total market capitalization with $9.5 trillion compared to $38.7 trillion for the United States and third largest stock market by float-adjusted market capitalization with $3.7 trillion compared to $4.7 trillion for Japan and $33.7 trillion for the United States. The reason why it is not the third largest weight in global indices is the 20% weight multiplier and the fact that China A-shares has a long tail of stocks from large cap to small cap. China A-shares has 4,040 stocks compared to 1,238 mainland Chinese stocks listed in Hong Kong and 232 listed in the United States.
But why not just invest in mainland Chinese stocks listed in Hong Kong or the US? The short is answer is China A-shares is far more diversified from an industry perspective, is a better diversifier from a covariance perspective in a global portfolio, and has a massive amount of alpha to be captured. We will discuss each of these in turn.
“Investing in China” versus “Investing in China A-Shares”
If you were to say you invest in Chinese stocks, that could mean many things. It could mean that you invest in China ADRs like Alibaba or JD.com—that is, Chinese firms with depository receipts in the United States. It could mean that you invest in mainland Chinese stocks listed in Hong Kong like Tencent Holdings. These are made up of H-shares, Red Chips, and P Chips. Lastly, it could mean that you invest in China A-shares—equities listed in Shanghai or Shenzhen. I will ignore the comparatively few and increasingly illiquid China B-shares, which are listed in Shanghai or Shenzhen, but are investable from outside China.
But despite all being Chinese stocks, these different exchanges list very different types of firms. H-shares, Red Chips, and P Chips (which we will call “HRP” for short) and ADRs are disproportionately more likely to earn their revenue through online transactions. They also tend to be fewer but larger, while China A firms are multitudinous but smaller cap.
These differences matter. Retail firms and specifically tech retail firms are heavily represented in ADRs and HRP. The largest China ADRs by market capitalization are Alibaba, JD.com, and NetEase. Alibaba and JD are large online retailers while NetEase is an online gaming company. The largest HRP stocks are Tencent Holdings and Meituan-Dianping both of whom earn their money primarily through online transactions.
But what of the largest A-share stocks? They are Kweichow Moutai, a distiller; Ping An Insurance Group, an insurance company; China Merchants Bank, a bank; Wuliangye Yibin, another distiller; and Jiangsu Hengrui Medicine, a pharmaceutical company. China A-shares in general are far more diverse with weights more equally distributed across industries.
Diversification
We already discussed how China A-shares are more diversified from an industry perspective, but I want to discuss the more traditional type of diversification—return correlation. If you already hold a portfolio of U.S. stocks, developed ex U.S. stocks, or EM ex China stocks, you can get a massive diversification benefit from investing in China A-shares, but not nearly as much of a diversification benefit from investing in China Offshore (primarily, HRP and China ADRs).
A portfolio that wants to minimize risk would hold China A-shares in excess of its free float weight to take advantage of the low return correlation with a global portfolio. But this is just the beta case for investing in China A-shares. There is also an alpha case.
Inefficiencies
What is the most fundamental thing we have learned about active management in the United States? Active managers tend to underperform indexes after fees. However, the same is not true for Chinese fund managers. Chinese active equity fund managers outperform even after their rather high fees. Moreover, they earn their alpha through stock selection, suggesting that, at least over the examined period, one could earn alpha cross-sectionally through stock picking.
Another way to answer this question is through the alpha that you can earn from implementing standard quant factors. An equally weighted portfolio of standard quant factors performs better in China A-shares than in emerging markets, which in turn outperforms such a portfolio in the United States.
Accessing China A-Shares
We have made the case that China A-shares is more diversified on an industry level than mainland Chinese stocks listed in Hong Kong or the United States, that A-shares are more numerous and smaller cap, that they provide greater return diversification for a global investor, and that they are more inefficient. But how does one get access to China A-shares?
One option is to apply for a qualified foreign institutional investor (QFII) quota, but I imagine this is not particularly compelling if you want to invest in public equities. Alternatively, you can buy stocks through Hong Kong Stock Connect as long as your broker supports it.
But for most, this is too effortful. Unless you have truly substantial sums of money and an eye for alpha opportunities in the middle kingdom, using a less labor-intensive approach is likely sensible. ETFs and mutual funds are likely the way to go for most investors. Given the alpha opportunity, this is a rare instance in equities where active management may be more sensible than passive.
Whatever approach you take to gaining A-share exposures, a fully diversified portfolio likely holds some China A-shares and more than is found in most indices.
First Published by Rayliant Global Advisors
Chapter 1: Allocating to China A-Shares
Published on March 1, 2021
Vivek Viswanathan
Global Head of Research, Senior Managing Director at Rayliant Global Advisors, Co-Portfolio Manager of Rayliant Quantamental China Equity ETF
This is the first installment in a series of articles on Investing in China A-shares.
Quick and important disclaimer: The analysis and views expressed in this discussion are my own and do not necessarily represent the views of my employer or any organization I am affiliated with. Nothing in this article constitutes investment advice or a recommendation to buy or sell any security.
You are probably under-allocated to China A-shares. This may seem an uninteresting statement at first glance. China A-shares—that is, stocks listed in the Shanghai or Shenzhen Stock Exchanges—make up 0.65% of MSCI ACWI. Even being completely unallocated to China A-shares seems perfectly rational. Why would you expend any mental energies on such a small allocation? By contrast, China ADRs and H-shares, Red Chips, and P Chips (mainland Chinese stocks listed in Hong Kong) make up a bit less than 5% of ACWI. In fact, a single Chinese ADR, Alibaba, has a 0.78% weight in ACWI. Sweden has a 0.93% weight. And yet, I am not writing articles about precisely what allocations to Alibaba or Sweden should be. But there are reasons you should focus more on China A-shares.
The first is that China A-shares has a 20% multiplier applied to its weight in MSCI ACWI. In other words, if it were included at its full float-adjusted market capitalization, its weight would be roughly 5 times higher at 3.25%. There was some sense to this multiplier before as A-shares were less easily accessible and more likely to be suspended from trading. However, because of the Hong Kong Connect Program, China A-shares are easily accessible, far easier than stock markets like India’s, which is included at full weight. Moreover, while stocks can be suspended, the percentage of stocks that are suspended have dropped dramatically and currently stands at about 0.5%.
In other words, if you are allocating similarly to MSCI ACWI or MSCI Emerging Markets, then you are underweight China A-shares relative to its free float market capitalization and for reasons that do not hold particularly well anymore.
But even that 3.25% weight does not do China A-shares justice. China A-shares is the second largest stock market by total market capitalization with $9.5 trillion compared to $38.7 trillion for the United States and third largest stock market by float-adjusted market capitalization with $3.7 trillion compared to $4.7 trillion for Japan and $33.7 trillion for the United States. The reason why it is not the third largest weight in global indices is the 20% weight multiplier and the fact that China A-shares has a long tail of stocks from large cap to small cap. China A-shares has 4,040 stocks compared to 1,238 mainland Chinese stocks listed in Hong Kong and 232 listed in the United States.
But why not just invest in mainland Chinese stocks listed in Hong Kong or the US? The short is answer is China A-shares is far more diversified from an industry perspective, is a better diversifier from a covariance perspective in a global portfolio, and has a massive amount of alpha to be captured. We will discuss each of these in turn.
“Investing in China” versus “Investing in China A-Shares”
If you were to say you invest in Chinese stocks, that could mean many things. It could mean that you invest in China ADRs like Alibaba or JD.com—that is, Chinese firms with depository receipts in the United States. It could mean that you invest in mainland Chinese stocks listed in Hong Kong like Tencent Holdings. These are made up of H-shares, Red Chips, and P Chips. Lastly, it could mean that you invest in China A-shares—equities listed in Shanghai or Shenzhen. I will ignore the comparatively few and increasingly illiquid China B-shares, which are listed in Shanghai or Shenzhen, but are investable from outside China.
But despite all being Chinese stocks, these different exchanges list very different types of firms. H-shares, Red Chips, and P Chips (which we will call “HRP” for short) and ADRs are disproportionately more likely to earn their revenue through online transactions. They also tend to be fewer but larger, while China A firms are multitudinous but smaller cap.
These differences matter. Retail firms and specifically tech retail firms are heavily represented in ADRs and HRP. The largest China ADRs by market capitalization are Alibaba, JD.com, and NetEase. Alibaba and JD are large online retailers while NetEase is an online gaming company. The largest HRP stocks are Tencent Holdings and Meituan-Dianping both of whom earn their money primarily through online transactions.
But what of the largest A-share stocks? They are Kweichow Moutai, a distiller; Ping An Insurance Group, an insurance company; China Merchants Bank, a bank; Wuliangye Yibin, another distiller; and Jiangsu Hengrui Medicine, a pharmaceutical company. China A-shares in general are far more diverse with weights more equally distributed across industries.
Diversification
We already discussed how China A-shares are more diversified from an industry perspective, but I want to discuss the more traditional type of diversification—return correlation. If you already hold a portfolio of U.S. stocks, developed ex U.S. stocks, or EM ex China stocks, you can get a massive diversification benefit from investing in China A-shares, but not nearly as much of a diversification benefit from investing in China Offshore (primarily, HRP and China ADRs).
A portfolio that wants to minimize risk would hold China A-shares in excess of its free float weight to take advantage of the low return correlation with a global portfolio. But this is just the beta case for investing in China A-shares. There is also an alpha case.
Inefficiencies
What is the most fundamental thing we have learned about active management in the United States? Active managers tend to underperform indexes after fees. However, the same is not true for Chinese fund managers. Chinese active equity fund managers outperform even after their rather high fees. Moreover, they earn their alpha through stock selection, suggesting that, at least over the examined period, one could earn alpha cross-sectionally through stock picking.
Another way to answer this question is through the alpha that you can earn from implementing standard quant factors. An equally weighted portfolio of standard quant factors performs better in China A-shares than in emerging markets, which in turn outperforms such a portfolio in the United States.
Accessing China A-Shares
We have made the case that China A-shares is more diversified on an industry level than mainland Chinese stocks listed in Hong Kong or the United States, that A-shares are more numerous and smaller cap, that they provide greater return diversification for a global investor, and that they are more inefficient. But how does one get access to China A-shares?
One option is to apply for a qualified foreign institutional investor (QFII) quota, but I imagine this is not particularly compelling if you want to invest in public equities. Alternatively, you can buy stocks through Hong Kong Stock Connect as long as your broker supports it.
But for most, this is too effortful. Unless you have truly substantial sums of money and an eye for alpha opportunities in the middle kingdom, using a less labor-intensive approach is likely sensible. ETFs and mutual funds are likely the way to go for most investors. Given the alpha opportunity, this is a rare instance in equities where active management may be more sensible than passive.
Whatever approach you take to gaining A-share exposures, a fully diversified portfolio likely holds some China A-shares and more than is found in most indices.
First Published by Rayliant Global Advisors