As China’s weight within global equity indices increases and its markets mature, should investors consider a dedicated All-China allocation or continue gaining their Chinese equities exposure via international or emerging market (EM) allocations? Our research suggests that despite the growing opportunity, investors are typically under-exposed to Chinese equity.
Our analysis and history also suggest that concerns about US-China tensions—a key reason many investors are cautious on China—are on balance a manageable long-term risk that should not preclude investors from embracing this opportunity.
Chinese equity markets are rapidly changing. Whereas historically China’s economy was powered by State Owned Enterprises (SOEs), the modern economy is increasingly driven by small- and mid-size private companies, foreign investment, increasing capital supply and investment in biotech, artificial intelligence, 5G and other innovative sectors.
Five reasons for China optimism
As a result, we contend that All-China equity is the best way to take advantage of these trends. The market, from Hong Kong to A-share exchanges and the new Nasdaq-like STAR market, has matured and is evolving in five constructive ways:
1. China’s economy is no longer dominated by SOEs: SOEs have significantly reformed and the combination of the growing number of SOE privatizations and IPOs has overhauled the composition of Chinese equity indices (Exhibit 1), making markets more dynamic and efficient.
2. Corporate governance has improved: The reduced dominance of SOEs (often used as tools of government policy) and regulatory reforms that better align corporate interests with those of shareholders have changed the governance landscape.
3. Capital markets have developed: The development of China’s markets is illustrated by the number and market capitalization of listings in Shanghai, Shenzhen, Hong Kong and US-listed American Depositary Receipts (ADRs)— 5,333 companies worth $14.1 trillion at the end of June (Exhibit 2). That compares to the $7.8 trillion market capitalization of euro area equities.
4. China’s benchmark weightings are rising: China’s increasing weight in key benchmarks,
such as the MSCI EM Index and the MSCI All Country World Index, is accelerating the institutionalization of its markets. At the same time, the still relatively high proportion of trading conducted by local individual investors (often funded by margin debt) creates inefficiencies that can be exploited by savvy investors to derive potential alpha.
5. China’s new consumer buys domestic: China’s middle-and upper-income consumers increasingly buy domestic products, eschewing once-favored global brands. The dynamic nature of China’s corporate universe is seen in the fact that China is the “youngest” market regionally in terms of listing years of index constituents (Exhibit 3).
China is investing heavily in innovation
Beijing is also investing heavily in “new infrastructure”—technologies in which it wants to reduce its foreign reliance; artificial intelligence, 5G, cybersecurity, alternative energy, electric vehicles and semiconductors. Beijing is encouraging a startup culture it hopes can rival Silicon Valley while also attracting international investors. For example, China has filed one third of the world’s 5G patents (Exhibit 4).
Index tracking is a flawed approach to China investing
We believe that allocating to China by index tracking is the wrong approach because, among other reasons, MSCI ACWI weightings heavily favor large-cap firms with negligible exposure to faster-growing, domestic Chinese firms. In addition, MSCI’s EM Index (Exhibit 5) is similarly weighted toward offshore China at the expense of A-shares. So, allocating to China by tracking benchmarks is akin to gaining US equity exposure by overweighting mega-caps at the expense of everything else. An All-China equities allocation offers a more balanced approach and enhances the odds of capturing potential future returns.
Finally, investors should consider the alpha opportunity in Chinese equity markets, which still have inefficiencies that can exploited: Over the past decade, the median China A-shares strategy outperformed the MSCI China A Onshore index by 8.4%, annualized (Exhibit 6, see next page). Meanwhile, in global EM equities, the median manager only marginally outperformed while the median S&P 500 manager underperformed. So, for long-only equity investors, China offers a rare source of meaningful, sustainable alpha potential.
Conclusion
While the specific All-China allocation for any specific investor depends on such factors such as risk appetite, we believe that typical current allocations to China do not reflect the country’s bright prospects and that investors should consider an All-China allocation beyond current benchmark levels, now 5.1% of the MSCI ACWI Index. Less benchmark-sensitive investors that share our strong conviction in China’s improving outlook could consider an even larger allocation.
Column by Anthony Wong, CFA, Portfolio Manager Hong Kong and China Equity; William Russell, Global Head of Product Specialists; and Christian McCormick, CFA, Senior Product Specialist in China Equity in Allianz Global Investors.
Por Funds Society, Madrid
