China expertise not just about China
Although the launch of Stock Connect, the scheme to allow trading across the Shanghai and Hong Kong stock markets, has been delayed past October, the question for fund managers has not. What is their China strategy?
Most asset management companies add China A shares to their portfolios as new investment channels materialise, but it is a reactive process. Hardly any firms have prepositioned themselves to capture China investment opportunities.
That is because the timing around inclusion of China A shares into global indices is uncertain. To invest now for access to A shares at some point in the future requires paying today for people, product development, trading infrastructure and chasing mandates. But there is no clarity about when revenues might follow.
However, the handful of asset managers that are making such a commitment are building a long-term competitive advantage, and not just in China – but across emerging markets, and indeed, at a global level.
Christopher Ryan, managing director for Asia Pacific at MSCI in Hong Kong, argues most fund houses underestimate the impact China A shares will have on their portfolios’ performance once inclusion takes place. He also argues that the passive approach, waiting for clarity, may prove an even costlier strategy over time.
That is because China exposure, particularly A shares, delivers diversification benefits that are simply unique at that scale. The A-share market has been out of sync with other large emerging stock markets, and indeed global stock markets.
Correlations count
Most emerging markets have become correlated with the US and other developed markets. Many sectors have become globalised (think autos, or tech), and trade and financial connectivity mean stocks often move in tandem.
China A shares not only have unusually low correlations to the US, they are also uncorrelated to other emerging markets – presumably due to the country's capital controls. The only other part of the global equities landscape to exhibit low correlations is frontier markets, which are tiny and illiquid. But the A-share market has a total market capitalisation of $3.9 trillion.
China’s market is so large that it could double foreign inflows overnight without it materially impacting prices – meaning as China further opens to foreigners, it is presenting them with a good way to add alpha-generating opportunities to portfolios. That suggests they deserve a premium, said Wang Qi, executive director at MSCI in Hong Kong.
Although China A shares may not yet constitute a big part of global stock portfolio allocations, they will increasingly come to dominate Asia and emerging-market dedicated portfolios.
To win institutional mandates requires a three-year track record. If China becomes a bigger part of indices and mandates, will managers have investment and analyst teams with depth and seniority?
“These things take time to plan,” Ryan said. “Not enough managers are asking themselves how China inclusion will impact their revenues.”
Not just about China
Those houses most at risk of a change in fortunes by China's inclusion are those with large emerging-market or Asia-Pacific equity businesses.
‘China’ is already 18% of the MSCI Emerging Markets Index, including B shares, H shares, red chips and P chips. Of the $4.2 trillion benchmarked against the MSCI Emerging Markets Index, nearly $769 billion is invested in ‘China’.
Investors are grappling with both how to access A shares, as well as how to benchmark Chinese companies listed in the US, such as Alibaba, Baidu and Tencent – giant companies that are not in the S&P 500 Index, the Russell 2000 Index or MSCI’s China Index or Emerging Markets Index.
But as these stocks do become more accessible, or more coherently categorised, Ryan said it will be those managers with a head start on building investment track records and market expertise that have the best shot at not just winning new China-focused mandates, but delivering more ways to outperform for existing Asia and emerging-market strategies.