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Get domestic growth via the China A-list

Chinese A-shares offer exposure to the fastest-growing companies in the world's second-largest, economy but come with added risk
February 2, 2017

The recent Chinese new year may have got you thinking about investing in China, which could benefit from strong domestic growth, albeit with some high volatility along the way, as we reported last week. To tap in to this economy's domestic growth potential, you need exposure to the companies that will benefit from this, and many of these are likely to be listed as A-shares.

China A-shares are quoted in the Renminbi currency, and traded on the Shanghai and Shenzhen stock exchanges, in contrast to H-shares which are traded on the Hong Kong Stock Exchange and open to international investors. Some companies have a dual listing in both onshore A-shares and offshore H-shares.

Historically, the onshore market has been heavily restricted to foreign investors, but since 2014 a Stock Connect programme has linked international investors on the Hong Kong exchange to the Shanghai market. In December 2016 this was extended to the Shenzhen exchange.

There are important differences between the types of companies listed offshore and onshore, and the returns investors can expect from them. The Hong Kong market, which the MSCI China Index is composed of, has a large-cap orientation. MSCI China is composed of 150 constituents with an average market cap of $7bn (£5.6bn), and dominated by large internet companies such as Tencent (HKG:700), which accounts for 13 per cent of it. The three largest industry sectors are information technology (32 per cent), financials (27 per cent) and consumer discretionary (9 per cent).

MSCI China A-share Index has 861 companies with an average market cap of $1.9bn. Its largest industry sector is financials (24 per cent), followed by industrials (19 per cent) and consumer discretionary (12 per cent).

David Liddell, chief executive of online investment service IpsoFacto Investor, says: "The exposures in the two markets are very different and funds just investing in Hong Kong tend to be dominated by the largest companies in this index. But I think it should really pay to have professional active management that can pick the best companies from both markets and exploit any valuation anomalies."

 

A-share advantages

Adrian Lowcock, investment director at Architas, says the onshore A-share market includes many domestically focused companies well placed to tap in to China's consumer growth. More than 50 per cent of Chinese gross domestic product (GDP) is created by domestic consumption, which also accounts for 90 per cent of GDP growth.

"Once upon a time, as an investor the idea was that you'd buy the [likes of] Apple (AAPL:NSQ) and Amazon (AMZN:NSQ), and they would grow market share by exporting to China," says Mr Lowcock. "What's actually materialised is that China learnt methods from those companies and has supported its domestic champions, such as Alibaba (BABA:NYQ) and Tencent, and many of those companies are listed onshore."

JPMorgan Chinese Investment Trust (JMC) has 11.5 per cent of its assets in China A-shares. "China is a two-speed economy," says Jennifer Wu, client portfolio manager at JPMorgan Asset Management. "Old industrial China is in structural decline and 'new China' will drive the growth in areas that are more consumption and services driven. One major reason why we think A-shares are the way to go is that they are Chinese companies that are domiciled onshore, tend to be privatised and reflect more of the domestic, dynamic businesses of new china."

The trust's largest sector weighting is information technology, which accounts for 31.4 per cent of its assets, followed by financials at 23.8 per cent and consumer discretionary at 15.6 per cent.

The dramatic sell-offs in the onshore market that took place in summer 2015 and early 2016 mean A-shares are now more attractively valued, so the trust has been able to top up existing holdings and add stocks its managers felt were too expensive in the recent past.

The trust's Chinese A-share holdings are also likely to be of benefit when these are eventually included in global indices. Last year, index provider MSCI decided against the inclusion of A-shares in its China index due to concerns over access and transparency in Chinese capital markets. If A-shares are included in the future, they will make up close to 50 per cent of the index.

"China has come a long way in getting over the operational issues and is making progress towards capital market reform, so we think it's no longer a question of if but when [A-shares are included]," says Ms Wu. "Those who benchmark these indices will have to make a strategic allocation towards A-shares, when they are included."

Investors who have exposure to A-shares before they are included in wider indices should benefit from any rally in their share prices that follow their inclusion. Funds that do not currently have much of an exposure to the market will be left playing catch-up, adds Ms Wu.

Fidelity China Special Situations (FCSS) has 9.4 per cent of its assets in China A-shares. Gary Monaghan, investment director at Fidelity International, says the onshore market is still under-researched, which means investors are more likely to find mispriced stocks. And although the market can be volatile, sharp downturns can mean great buying opportunities.

The trust's largest sector weighting is consumer discretionary, which accounts for 35 per cent of its assets, followed by information technology at 31 per cent.

Mr Monaghan says: "We are pretty agnostic to where a stock is listed, so long as it is a great business that offers long-term growth prospects, is cash-generative, well managed and trades at an attractive valuation."

 

Not A-OK

However, while A-shares offer access to some of China's fastest-growing companies. investing in them also involves a number of risks.

"The risk of liquidity issues and state intervention is much greater for onshore shares," says Mr Liddell. "In July 2015 trading in over 90 per cent of the 2,774 shares then listed on Chinese exchanges was suspended or stopped as a result of massive volatility in share prices. Again in January 2016, trading was suspended on China's stock markets when the main index fell 7 per cent and triggered a new rule meant to limit volatility. There will always be a temptation for the authorities to intervene in ways that are not shareholder friendly if they don't like the way markets are performing."

Onshore companies look expensive as a whole compared with offshore companies, adds Mr Liddell.

And because the onshore market has been dominated by retail investors it has experienced high volatility. "Volatility has been caused by leveraging - individuals in China have been able to borrow money to invest - which isn't a characteristic that you get in the UK where you need to have cash in the bank to buy shares," explains Mr Lowcock. "There weren't many strict controls in the past, so when markets started rising, investors got more confident and started borrowing more. Then they got overconfident, which caused the whole thing to crash. This ability to borrow creates a massive bubble and exaggerates trends."

Although Mr Lowcock expects less extreme volatility in future as the Chinese government has tightened the rules following the crash in summer 2015, there are still risks to investing in a market traded by many non-professional investors.

Another way in which the Chinese domestic market differs from Hong Kong or other international exchanges which list Chinese companies, is its degree of shareholder protection.

"There's always been a risk in China as in any emerging market that shareholder rights are not the same as in developed markets," says Mr Lowcock. "You don't get the same protection as you do in the West: if you buy a Chinese company listed on the New York Stock Exchange it has different shareholder rights than one listed on the China A-share domestic market."

Mr Lowcock is also wary of Chinese state-owned enterprises, which can be found on both the onshore and offshore markets, because of their lack of shareholder focus. He adds that these businesses are run on behalf of the government, and can be inefficient and laden with debt.

Mr Liddell agrees offshore listed companies offer greater shareholder protection and liquidity, but adds: "Most large offshore companies are still very exposed to the Chinese economy, so if that starts to slow or US President Donald Trump initiates a trade war they will suffer as well. This is obviously a major risk facing both classes of share, as well as the high level of private sector debt in China."

 

Accessing China's growth

If you are able to tolerate the risks associated with China A-shares, there are a number of exchange traded funds (ETFs) that offer exposure to this market. However, these can be volatile and track less well than ETFs focused on offshore Chinese shares, one reason why Mr Liddell favours actively managed investment trusts, which he thinks generally perform better in volatile emerging markets such as China.

He also prefers investment trusts to active open-ended funds for investing in China as there is no risk that they will have to sell assets to meet investor redemptions, meaning they can invest in shares over a long period and sit tight through any periods of volatility or liquidity problems.

Regarding underlying market exposure, Mr Liddell prefers trusts that have a mixture of domestic A-shares and offshore listed Chinese companies, such as Fidelity China Special Situations and JPMorgan Chinese Investment Trust.

Mr Lowcock also thinks it is important that active China funds are able to access both A-shares and offshore shares, although doesn't mind which type they focus on.

"China fund managers specialise in these markets, so let them make the decision [on which shares to hold]," he says. "Just as they decide which stock to pick, they'll also decide which share of the stock to pick."

He favours JPMorgan Emerging Markets Income (GB00B5N1BC33) as a diverse fund offering broad exposure to emerging markets. "JPMorgan Emerging Markets Income is a broader emerging markets fund which will give exposure to Chinese stocks, usually through Hong Kong or Taiwanese markets," says Mr Lowcock. "The focus of the fund is very much on stock selection with a bias to quality value stocks, which then drives exposure to countries. This means that Chinese exposure features in the portfolio on merit alone. This fund is more suitable for cautious investors wanting to access the Chinese markets."

The fund's largest geographic exposure is to Taiwan, accounting for 21 per cent of assets. It invests in two China A-shares, which account for 4.2 per cent of its assets - Midea (000333.SZ) and Fuyao Glass (600660:SHH).

For more specialist exposure, Mr Lowcock suggests GAM Star China Equity (IE00B3CTFS84). "Its manager Michael Lai runs a very active fund, which looks to generate return by investing in growth at a reasonable price," says Mr Lowcock. "He and his team also look to identify points of change in industries and businesses. GAM Star China Equity will give investors access to growth in China, but also exposure to any sell-offs in the market, so is more suitable for those willing to take more risk."

 

Fund performance

Fund/benchmark1-year share price/total return (%)3-year cumulative share price/total return (%)5-year cumulative share price/total return (%)Ongoing charge including any performance fee (%) *
JPM Emerging Markets Income 52.134.4na0.93
GAM Star China Equity 34.432.161.91.02
JPMorgan Chinese Investment Trust48.037.663.21.44
Fidelity China Special Situations52.186.8132.22.22
MSCI Emerging Markets index NR USD48.839.727.3
MSCI China index NR USD 44.654.052.3
IA Global Emerging Markets sector average46.737.728.7
IA China/Greater China sector average41.348.058.9

Source: Morningstar as at 27/01/17, *Morningstar and the AIC