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China access to get easier

Including domestic Chinese shares in broader indices will improve access
May 24, 2018

As the world's second-largest economy, China is an area long-term growth investors cannot ignore. However, accessing this country's growing companies has not been easy.

This is because many emerging markets and Asia Pacific active funds and exchange traded funds (ETFs) invest in Hong Kong-listed companies known as H-shares, rather than Chinese mainland-listed A-shares. Funds and ETFs that hold or have exposure to A-shares are the exception rather than the norm. 

However, index provider MSCI is going to include Chinese mainland listed A-shares in its Emerging Markets index from June this year.

A-shares have historically been more volatile than H-shares for reasons such as capital controls, lack of openness in the market and a non-diverse investor base. But their inclusion in MSCI Emerging Markets index will be gradual so should not have much impact on returns in the short term. Next month 234 China A-shares will be added to MSCI Emerging Markets index, which will account for less than 1 per cent of its total capitalisation. However, if eventually all A-shares are included they would account for 17 per cent of MSCI Emerging Markets index's value, and together with H-shares account for 41 per cent of it.

"Such a prominence of A-shares within MSCI indices would clearly be significant, both for passive investors looking to replicate them and active investors who seek to outperform them," says Mark Williams, manager of Liontrust Asia Income Fund (GB00B7BZB324).

Including Chinese A-shares in MSCI Emerging Markets index could change their valuations, meaning that investors need to rethink what the best way to access the region is or whether they should have exposure at all. 

Mr Williams thinks that investors should hold back from getting exposure to A-shares until they have been trading more openly for some time, as over time their valuations should reduce.

"We currently find more opportunities outside the A-shares market due to the expensive valuations of domestic Chinese equities," he says. "The [A-shares stock exchanges in Shanghai and Shenzhen] trade on prospective price/earnings (PE) ratios of 12 times and 20 times respectively. Hong Kong-listed shares of Chinese companies [in the Liontrust Asia Income fund] trade on an aggregate PE ratio of 11 times, less than the Hong Kong-listed companies index and also less than the A Shares."

This is because the restricted access to A-shares for foreign investors means that about 80 per cent of their value is held by Chinese domestic private investors, according to Bloomberg, as they have few other options in terms of where they invest their savings. It also means that this market is probably driven more by these investors' sentiment than fundamental valuations of stocks.

"But as international market exposure increases, we believe that the fundamentals [in A-shares] will become more assertive," says Mr Williams. "A narrowing of the A-share/H-share premium would be one signal that domestic investor sentiment is having less influence on stock movements."

 

Think before you invest

There are many other things to consider when deciding if, how, when and how much to allocate to Chinese shares.

Chinese equity markets have done well recently. MSCI China index, which is composed of Chinese companies listed outside the mainland on markets such as Hong Kong, has risen 94 per cent over the past five years, while MSCI China A-Shares index is up 57 per cent. MSCI China index did better because it includes tech giants such as Tencent (HK:700), Alibaba (US:BABA) and Baidu (US:BIDU). 

The MSCI China A-Shares index is more diversified and balanced by sector. For example, financials are its largest sector with a 25 per cent weight compared with MSCI China index's largest sector, technology, which has a weighting of 40 per cent.

With the prospect of more efficient markets and sustainable returns in the future, an allocation to Chinese equities could be profitable. Peter Dalgliesh, managing director at Parmenion Investment Management, says China's well-documented attempt to shift to consumer spending as a driver of economic growth, instead of manufacturing and government spending on infrastructure, is taking a long time but will eventually provide benefits. So for investors who want access to Chinese consumer businesses greater access to A-shares will be very useful.

"This transition is expected to result in slower relative economic growth, albeit more stable and sustainable," he explains. "For investors this suggests a medium to long-term outlook which is expected to remain rewarding but with marginally lower volatility."

Kasim Zafar, a portfolio manager at EQ Investors, adds: "As the size of the economy increases, the rate of growth will slow. This is less concerning to us since it creates a more stable, diversified economy. The core argument remains: a vast, young population that likes to spend and is getting richer. As 'made in China' continues to become 'designed in China', growth in the consumer, technology and related sectors remains extremely exciting."

But analysts such as Julian Evans-Pritchard, senior China economist at consultancy Capital Economics, think China's growth rate will decline and remain stubbornly low for years to come.

"The mainstream consensus view seems to be that the bulk of China's slowdown since the global financial crisis is over, but we are sceptical," he says. "Over recent decades China has followed a similar growth trajectory to Japan, Korea and Taiwan, which are among the few emerging markets that have successfully made the transition to high-income status. But China is reaching the limits of investment-led growth. China's only hope of sustaining its current rate of expansion is to find more effective ways of raising productivity. And, unfortunately, the current trajectory of policy making seems more likely to hinder rather than help."

A region over which sentiment is split has the potential be more volatile, and as China is still an emerging market it is already victim to swings in sentiment. This means that if you invest in China you need to be able to tolerate volatility, and have a high risk appetite and a long-term investment horizon of at least five years or preferably longer.

 

Best funds for China

If you have the risk appetite to invest in Chinese equities there are several ETFs that track the MSCI Emerging Markets, MSCI Asia Pacific ex Japan and MSCI Far East ex Japan indices, which allocate to China in varying amounts.

IndexWeighting to China (ex A-shares) (%)
MSCI Emerging Markets30.10
MSCI All Country Asia Pacific ex Japan34.55
MSCI All Country Far East ex Japan38.31
MSCI All Country World3.62
Source: MSCI as at 30.04.18

 

For ETFs that track MSCI China index and CSI 300 index which comprises mainland A-shares, see the IC Top 50 ETFs on pp 20-33.

With active funds, many professional investors advocate using a broad emerging markets or Asia Pacific fund of which the manager can decide how much to allocate to China.

Mr Zafar says EQ Investors uses active managers, in particular for China A-shares which require "extensive attention to detail" because standards of corporate governance in emerging markets are not as good as in developed markets. EQ Investors is positive on the region so invests its clients in Asia and emerging markets funds that have a significant allocation to China.

Rory McPherson, head of investment strategy at Psigma Investment Management, says they take a more cautious approach and allocate to Asia more broadly, but with some exposure to Chinese consumer stocks or stocks which should benefit from a rise in Chinese consumer spending.

Mr Dalgliesh says Parmenion also favours using broader emerging markets and Asia Pacific funds rather than deciding themselves exactly how much to allocate to China.

There are over 120 funds with over 20 per cent of their assets allocated to Chinese shares in the Investment Association (IA) Global Emerging Markets, Asia Pacific Excluding Japan and Asia Pacific Including Japan sectors. And there are 10 investment trusts that have 20 per cent or more of their assets invested in Chinese shares.

Options include Hermes Global Emerging Markets Fund (IE00B3DJ5K90), which has almost 40 per cent allocated to China, and its 10 largest holdings include Tencent and Alibaba. Its manager, Gary Greenberg, selects stocks based on their individual merits, and the fund's substantial weighting to technology companies has boosted its performance recently. It has returned 53 per cent over three years and 17 per cent over one year – well ahead of MSCI Emerging Markets index and the IA Global Emerging Markets sector average. Over five years it is the best-performing fund in this sector.

Veritas Asian Fund (IE00B02T6J57) has a 37 per cent weighting to China but with a broader sector focus than Hermes Global Emerging Markets. Its top 10 holdings also include Tencent but the fund has a 20 per cent allocation to financials and 28 per cent in consumer stocks. It invests in both Asian emerging and developed countries. Over one year, Veritas Asian has returned 25 per cent versus 17 per cent for MSCI All Country Asia ex Japan index. The fund has been run by Ezra Sun since 2004.

BlackRock GF Asian Growth Leaders (LU1085282496) has more of a balance between value and growth stocks, and despite its large size with assets of over £4bn, a greater focus on medium-sized companies. The fund's holdings have an average market capitalisation of £20.1bn, compared with £29bn for the constituents of MSCI All Country Asia ex Japan index, and a £32bn average market capitalisation size for the holdings of funds in the Morningstar Asia ex Japan sector. As a result of lower exposure to mega cap and tech stocks that have done well, recent performance is not spectacular, but the fund provides the potential for uncorrelated returns. It is run by experienced managers Andrew Swann and Emily Dong.

Pacific Horizon Investment Trust (PHI) has over 40 per cent allocated to China and Hong Kong, and Tencent and Alibaba are its two largest holdings. It has vastly outperformed with returns 87 per cent and 47 per cent over three and one years, against 44 per cent and 17 per cent for MSCI All Country Asia ex Japan index and the Association of Investment Companies (AIC) Asia ex Japan sector average returns of 37 and 11 per cent. However, this performance means the trust's share price has moved to a 2.9 per cent premium to net asset value, in contrast to the discount at which it has traded for many years, so it might be better to buy this at a cheaper entry point. The trust is managed by Ewan Markson Brown and Roderick Small at Baillie Gifford.

There are also around 40 single country China funds. However, the best performers among these over three years hold Alibaba, Tencent and Baidu in their top 10 holdings, which are also often held by broader emerging markets and Asia Pacific funds. So there seems little differentiation to gain for more concentrated risk.

 

Performance of suggested funds

Fund/benchmark1-year total return (%)3-year cumulative total return (%)5-year cumulative return (%)Ongoing charge (%)*
Pacific Horizon Investment Trust share price47.1787.12113.371.07
BlackRock GF Asian Growth Leaders13.1149.4495.041.12
Veritas Asian24.9368.44106.931.17
IA Asia Pacific Excluding Japan sector average13.9842.3650.99 
AIC Asia Pacific ex Japan sector share price average11.2737.0837.42-
MSCI All Country Asia ex Japan index16.6944.4161.78-
Hermes Global Emerging Markets16.7952.7773.321.13
IA Global Emerging Markets sector sector average10.4634.2430.48-
MSCI Emerging Markets index13.3637.8637.57-
Source: FE Analytics as at 22.05.2018 *From fund provider factsheets as at 30.04.2018