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China’s onshore A share market is the second largest in the world by market capitalisation, yet to date various issues have resulted in low foreign investor participation. In this paper, Bill Dwyer and Raymond Lam (from JANA's Global Equity Research team) provide an overview of China's A share market and insights from their recent research trip to Shanghai and Shenzhen in China, Hong Kong and Singapore.
During this research trip, JANA met with a range of local and foreign fund managers, including Joint Ventures (JVs) and Wholly Foreign Owned Enterprises (WFOEs). We also met representatives of the Shanghai Stock Exchange and joined fund managers for company visits in Shenzhen and Hong Kong. Based on the research conducted, JANA believes that it has useful insights on how to best structure an investment into the China A share market, which is likely to be the emerging market of the 21st century.
Chinese Equity Markets
Foreign investors have historically encountered various restrictions in accessing China’s onshore equity markets. As a result of these restrictions, various distinct share classes have arisen based on where a Chinese company is incorporated, its country of listing and the trading currency used. The following table provides a brief overview of the differences between these share classes.
Given recent developments that have improved investor accessibility to China's onshore A share market, JANA recommends utilising both onshore and offshore channels to capture the broadest equity opportunity set for China. This unified 'All China' approach deconstructs the separate share classes that have arisen due to the distinct nature of China's market liberalisation path and instead allows investing across the broad opportunity set whilst being agnostic to access channels.
A Shares – The emerging market
Chinese offshore equities have traditionally been favoured by foreign investors seeking to gain exposure to Chinese equities. However more recent developments have addressed some of the historical impediments to investing in China’s onshore A share market:
Chart 1 – Stock Suspensions
The addition of A shares to the Chinese equity opportunity set provides additional diversification benefits as illustrated in Chart 2. The MSCI International China index represents the traditional offshore markets accessed by foreign investors, whilst the MSCI China A Onshore Index represents China’s domestic market (1). There is an evident skew towards the IT sector within the International China index, reflecting a large weighting towards the 'BAT' IT stocks (Baidu, Alibaba and Tencent). Notwithstanding the large weighting towards the Financials sector, the China A onshore index is more broadly diversified across sectors and has greater exposure to the Consumer Discretionary and Health Care sectors which are integral to the Chinese consumer theme.
(1) The MSCI International China index captures large and mid-cap representation across Chinese securities traditionally accessed by foreign investors (i.e. H shares, B shares, Red chips, P chips and ADRs), whilst the MSCI China A Onshore index captures large and mid-cap representation across Chinese A share securities listed on the domestic Shanghai and Shenzhen stock exchanges.
Chart 2 – GICS Sector Weights
Including access to onshore A share stocks is expected to increase the breadth of investment opportunities that can leverage structural trends and characteristics specific to China.
Examples of prominent China A share stocks held by foreign investors include:
The main implication of China being a large part of MSCI’s Emerging Markets index is that this index will become increasingly driven by the returns of Chinese companies. As can be seen in Chart 3, the Emerging Markets index already comprises around a 31% exposure to Chinese companies, and this exposure has increased significantly over the past eighteen years.
Chart 3 – MSCI Emerging Markets Index
Whilst there is now a small weighting to the China A share market based on MSCI's initial 5% inclusion factor as shown in Chart 4, the vast majority of Chinese companies in the Emerging Markets index are still listed on China’s offshore equities markets. In the event of full inclusion of China A shares in the index (i.e. 100% inclusion factor), MSCI projects Chinese equities would represent 42% of the Emerging Markets index, with around 40% of these stocks listed in the China A share market.
In order to attain a 100% inclusion factor over time, China will need to continue making progress in improving foreign accessibility to its domestic markets and managing the prevalence and duration of trading suspensions.
Chart 4 – Projected Index Weighting
Investing in China A shares
The current dominance of retail investors trading in the China A share market as shown in Chart 5, results in a highly volatile market that is subject to short holding periods and high turnover. This is in contrast with the Australian share market, where institutional investors comprise the vast majority of trading volume. The alpha opportunity for actively managed strategies could be a valuable complement to the volatile beta within this highly inefficient market although, over time, as the market matures this degree of inefficiency may moderate.
Chart 5 – Retail vs. Institutional Trading Volumes
Given the size and idiosyncrasies of the Chinese equity market, JANA considers 'China specialists' (i.e. analysts with an overarching focus on the Chinese market) to be a valuable resource to any investment team covering this universe. JANA believes on the ground experience is a competitive edge for discretionary investment managers to gauge the pulse of regulatory developments in a market which is prone to State intervention.
Adequate local language skills (i.e. Mandarin Chinese) are recommended, given differences between Chinese and English-translated company and research reports, in addition to Mandarin being the preferred language for management teams and in conducting channel checks.
Whilst domestic fund managers may possess advantages with respect to local insights and on-the-ground resourcing, China’s institutional investment profession is less mature compared to global counterparts and represents a smaller proportion of trading volume in this market. JANA believes potential risks within domestic fund managers are the prevalence of retail-oriented investment philosophies, a large emphasis on short-term peer-relative performance and less developed risk controls.
There may be valid opportunities to engage with the more established domestic fund managers but there is a need for more comprehensive due diligence and proper consideration of which client segment the manager is predominantly catering towards (e.g. local retail investors or institutions) in making an assessment of the fund manager.
For foreign fund managers, adequate and specialised coverage are key to leveraging investment opportunities in China’s vast onshore market. Large foreign firms have typically gone down the route of forming JVs with domestic Chinese managers or alternatively setting up a WFOE (a limited liability company wholly owned by a foreign entity) in China.
JANA's preference is for WFOEs given the manager has more autonomy and direct control over both the investment process and personnel, although ensuring the venture is adequately resourced with critical mass is a key consideration. JANA does not rule out the feasibility of JVs but the calibre of the local Chinese partner and the working relationship between the two parties are critical to achieving success.
JANA’s research trip was extremely valuable in providing broad based validation of the thesis that investment in Chinese A shares is an opportunity that needs to be taken seriously. Chinese equities will dominate the Emerging Markets index in the not too distant future and A shares are an important component of the Chinese equity market, providing important diversification beyond the IT stocks that dominate the Chinese offshore market.
The historical barriers to entry into the Chinese onshore market have dissipated to a large extent, with residual structural market issues to be progressively resolved. Whilst there are various avenues to invest in the China A share market through fund managers, local knowledge and ‘on the ground’ research combined with strong due diligence are critical in selecting the appropriate method to gain access to the emerging market of the 21st century.
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