Has Covid-19 changed the case for China A-shares?

Chinese equities have started 2021 on the back foot somewhat, having outperformed in the darkest hours of the pandemic.

But their importance for global investors is still on the rise. The share of Chinese equities in global benchmark indices is still relatively low when compared with China’s share of global GDP.

In our view the travel of direction is clear. It could be beneficial for investors to increase their exposure to China A-shares now to reap the full benefits, as opposed to wait for index providers to increase China’s weight over time.

Why China remains poised to become more important to global investors

Global equities indices have gone through some significant changes over the decades. Some investors might remember that in 1988, Japan was 44% of the MSCI All Country World Index (ACWI). After a steady decline over 30 years, it now stands at only 6.5%, as at 31 March 2021.

Today the US is by far the largest constituent of the MSCI ACWI Index with a 58% share. This is more than double the US economy’s share of world GDP (25%). Meanwhile, China’s share of the MSCI ACWI Index is just under 5%, yet China accounts for 17% of world GDP, so it is underrepresented in the index relative to its economic heft. It is also worth bearing in mind that the IMF expects China’s share of world GDP to increase to 19% by 2025.

The key to understanding this gap is in the growing importance of the China A-shares market, which consists of stocks listed on the Shanghai and Shenzhen stock exchanges.

A quick recap on China A-shares

Once completely excluded from global indices, China A-shares have slowly made their way into major benchmark indices. This has been the result of a gradual opening-up of China’s capital markets to foreigners. Despite this significant development, the exposure which many investors get is still limited, and possibly not optimal.

Currently, 20% of the total market capitalisation of 470 A-share stocks is included in the MSCI Emerging Markets Index. As such, the inclusion factor is relatively low, as there are over 4000 stocks listed on the Shanghai and Shenzhen stock exchanges. Furthermore, the STAR board, launched in 2019 as China’s version of NASDAQ, is completely excluded from the MSCI indices.

One consequence is that the MSCI China Index is still dominated by stocks listed in Hong Kong SAR (H-shares, P-chips, Red-chips) and the US (American Depositary Receipts - ADRs), making up 34.8% of the MSCI Emerging Markets Index. By comparison, the share of the much larger A-shares market is only 4.7%, as the chart above illustrates. After the full inclusion, should it ever happen, the 470 stocks at 100% market cap would represent 19% on the MSCI Emerging Markets Index.

Below are the key the characteristics that make the A-shares market unique compared to its offshore counterparts.

1. High retail investor participation

One of the defining features of the A-shares market is the high retail investor participation, accounting for more than 80% of the average daily trading volume. This is a stark contrast to the H-shares market in Hong Kong SAR that is dominated by large institutional investors who account for 77% of the trading volume.

Why is this important? As retail investors often have shorter time horizons, and can overreact to near-term news flow, this can result in stocks being significantly under or overvalued. Hence retail investor dominance provides significant opportunities for more sophisticated investors with rigorous investment processes and longer investment horizon. These investors can take the other side of a trade and be rewarded for correcting the mispricing.

2. A wide selection of mid-cap stocks

Compared to the offshore parts of the market, including Hong Kong SAR listed stocks and ADRs, the market capitalisation of A-shares is more evenly distributed, with a long tail of mid-cap stocks. While these companies might be less known to international investors, they are no less part of the China growth story.

Importantly, investors can access companies in sectors that are otherwise unavailable in the offshore market. This includes sectors such as consumer goods (home furnishing retail, housewares & specialities, homebuilding), consumer services (travel & leisure), consumer staples (distillers), industrial automation, media and broadcasting, and healthcare.

Naturally, less liquid trading conditions and other restrictions could prevent investors from fully taking advantage of these opportunities. However, the majority of the A-shares mid-cap stocks are actively traded and accessible, allowing investors to deploy capital.

Importantly, while only 470 mid and large cap stocks are included the MSCI China Index, foreign asset managers can access the full opportunity set by using separate, firm specific Qualified Foreign Institutional Investor (QFII) quotas.

3. Relatively limited and low quality analyst coverage

Crucially, A-share stocks, especially smaller ones, have limited sell-side analyst coverage. The figure below shows the average number of analysts’ forecast per stock, three years out, for key global equity markets. The US stock market is known for its extensive analyst coverage, with the MSCI USA Index having on average 20 forecasts per stock for the next fiscal year.

The degree of coverage starts to fall as you move into broader developed markets, and it drops further in emerging markets. Looking at the MSCI China Onshore Index, it has on average less than 10 forecasts per stock. This is much less than in the MSCI China Index and the MSCI Emerging Market Index, which both have 14. Furthermore, 13% of the mid and large cap stocks in the MSCI China A Onshore index have no analyst forecasts at all.

On top of that, sell-side analysts are typically less experienced, and their recommendations often reflect the momentum of the market. All this can lead to information inefficiency and open up opportunities for long term investors who are willing to put in the effort and do their homework. 

4. Past issues with corporate governance

Another hallmark of the A-shares market has been relatively low corporate governance standards. This has contributed to market volatility and posed heightened corporate governance risk for investors. Low governance standards can be broadly explained by the fact that conventional checks and balances have been weaker than in other markets.

Specifically, the presence of independent directors on the boards of A-share companies is lower compared to most other countries, as seen in the figure below. Moreover, independent directors usually get paid relatively little, meaning there can be less incentive and time commitment from them. As a result, there can be less oversight of executive management by company boards.

The good news is that governance standards have started to improve, driven by the institutionalisation of the A-shares market. Institutional investors are emerging as a group powerful enough to steer the practice of corporations. In fact, the share of independent directors has increased from 38% to 48% in the last two years alone.

How does the performance of active stack up versus passive in the A-share market?

The characteristics we have highlight above, should, in theory, make the A-shares market a fertile ground for stock picking. But is this the case when looking at the performance of active A-shares managers?

In the five years to the end of March 2021, the median A-shares manager has outperformed its benchmark by a whopping 10.4% per annum^[1]. Clearly, this is an unprecedented level of alpha, not normally seen in other global equity markets.

Passive strategies in A-shares, on the other hand, have lagged their benchmarks, as highlighted by the performance of A-share ETFs. The ChinaAMC CSI 300 Index ETF is the largest A-share ETF that is available for offshore investors in Hong Kong SAR. Over the last five years, it has underperformed the CSI 300 Index, a benchmark consisting of the 300 largest and most liquid A-share stocks, by 2.8% per annum^[2].

Moreover, the underperformance is greater than what would be implied by the expense ratio (0.8%), pointing at the high cost of index replication in the A-shares market.

Could A-shares offer a diversification benefit in global stock portfolios?

Besides the significant alpha opportunities, the A-shares market could be an important addition to global equity portfolios because of its diversification benefits. The table below shows the correlations between global and Chinese equity indices.

The MSCI China A-share Index has about half the correlation with global equities than the MSCI China Index. This means that adding A-shares to global equity portfolios could help to reduce overall portfolio risk.

The lower correlation reflects the more diversified and domestic nature of A-shares. The MSCI China Index, on the other hand, has a high concentration of a handful of mega cap stocks, with Tencent and Alibaba making up 29% of the index.

Why emerging markets investors should consider a satellite A-shares allocation

We believe that the unique characteristics of the A-shares market warrants a satellite A-shares allocation, in addition to a global emerging markets mandate. Such an allocation would allow investors to access a much larger portion of the A-shares market, as measured by the number of stocks and their market capitalisation. The broader opportunity set is necessary to reap the full benefits, especially the large alpha opportunities.

Despite the improvements in recent years, there are still some issues with corporate governance in China. That is why it is paramount that a manager has the ability to carry out proper due diligence. This requires having boots on the ground, as well as an understanding of the language and local customs.

While these benefits can be available via a global emerging markets strategy, if a manager has the local capability, the satellite approach would significantly widen the breadth of the opportunity.

[1] Source: Schroders, Morningstar. Includes open-ended EAA equity funds. Returns are shown net of fees. Oldest retail share class preferred. Data as at 31 March 2021. Past performance is not a guide to future performance and may not be repeated.

[2] Source: ChinaAMC. Data as at 26 February 2021. Past performance is not a guide to future performance and may not be repeated.