Note to product developers: Unconstrained Greater China equity

Consultancy firm Towers Watson is seeking to plant a portfolio concept in the minds of product developers that is centred around unconstrained Greater China equity.

At the idea’s core would be an A-share component. Managers would also have flexibility to invest in red-chips, H-shares and P-chips (Chinese firms listed in Hong Kong and incorporated in Cayman Islands, Bermuda and British Virgin Islands) and B-shares in Shanghai and Shenzhen.

This universe could further be expanded to include equities in Hong Kong and Taiwan as well as various Chinese stocks listed in New York, Singapore and London.

“This is something we would like to see more of from the investment management community,” Calvin Wong, of Towers Watson’s manager research team, told a client forum last week. “We believe this sort of portfolio would benefit investors by allowing them to gain exposure to the full spectrum of beta and alpha opportunities in this space.”

But after a question from the floor about how clients could gain exposure to the A-share market given present capital controls, Wong conceded that putting such a portfolio together would be tough.

“One thing to keep in mind is that A-share exposure might need to be built up over time as the market opens up,” he noted. “When we are talking to clients about this portfolio idea, how to set the strategic weights and build a portfolio appropriately is something we spend a lot of time on.”

Wong had been stressing why China’s large public equities market – Towers Watson estimates the combined Greater China equity market cap to be $5.5 trillion across 5,000 listed firms – is a far better investment proposition than other China opportunities presently available.

He noted that there was a case for gaining exposure to the A-share market even if you are already exposed to red-chips and H-shares, given that with the onshore market you are buying more exposure to consumer plays, domestic healthcare and materials, while offshore is more geared towards energy, Chinese telcos and large-cap Chinese financials.

But he said the onshore bond market was not as relevant to institutional investors as the offshore (CNH) version on account of its limited accessibility, pointing out that the qualified foreign institutional investor (QFII) programme had still not given rise to pure bond-focused strategies.

And he suggested that the net value proposition for investing in the offshore RMB bond market – which he noted is gaining increasing interest from defined contribution-type pension funds – appeared relatively unattractive.

He laid out why the case is heavily weighted against investing in the CNH market (see image), with the majority of issues low-yielding; limited liquidity due to lack of a true secondary market (posing challenges for active bond management); limited size of the universe (making active securities selection difficult); limited number of issues rated by credit rating agencies; relatively expensive fees on bond products ranging from 30 to 100 basis points; and lack of a real benchmark.

In terms of the case for investing in the offshore RMB bond market, he said the main rationale would be anticipated renminbi appreciation – which as he pointed out is not guaranteed.

“For the time being we think the net value proposition for most CNH bond products in the market appears to be relatively unattractive,” said Wong. “Obviously this could change as the market grows and product structures change.

“But if appreciation of the RMB is all you are looking for, we think for now it might make more sense to hold RMB deposits directly as a more cost-effective option. But for diversification purposes it might make sense to include RMB bonds as part of a broader fixed income portfolio.”

When asked how he expected opportunities in the offshore bond market to play out – Towers Watson estimates that 75% of CNH issuance has been for maturities of three years or less as shorter maturities confer the clearest funding cost advantages to borrowers – he noted that the ability of issuers to sell bonds cheaply won’t last.

“Over the next five years we will probably see things evolve a lot more quickly,” he added.

The swift development of both China's onshore and offshore RMB bond market is something HSBC Global Asset Management also pointed to in excited anticipation at a lunch last week.

Over the past two years HSBC GAM has seen its fixed income AUM in the region rise by 50% to $31.5 billion as at the end of 2011, including $700 million in RMB bond assets.

Joanna Munro, its Asia-Pacific CEO, told AsianInvestor the firm expects to see the latter figure increase to $5 billion within the next five years. “This is still small as a percentage of our overall fixed income assets, but in terms of a growth opportunity it is very significant,” she said.

Noting the potential of the onshore market, she said the opportunity was coming around much faster than the bank had anticipated. “I would hope that in 2012 we would have the opportunity to offer an onshore RMB bond fund,” she forecast.

Geoffrey Lunt, senior fixed income product specialist for HSBC Global Asset Management, suggested that institutional clients are largely investing in the RMB bond market not only as a currency play but also to test the water and grow more familiar with the market.

“Overwhelmingly one of the reasons they want to be involved in the market is because they know it is going to be massive and they think that this is a good learning experience, or they see opportunities already,” he said.

“We need to be ready for when we can offer investors access to the onshore market because if it does become available you are talking about one of the most important capital markets in the world.”

HSBC Global Asset Management has a QFII quota of around $320 million, which it uses for its equity funds HSBC China Dragon Fund (launched in 2007) and HSBC China A-Share Fund (launched in 2009).