Another approach would be to look at the benchmarks’ inherent biases and try to seek out valuable names that can help their portfolios overcome those limitations. We think that global indices tend to overlook small- to mid-cap stocks in A shares. As for the CSI 300, a capitalization-weighted stock market index tracking the performance of top 300 stocks traded in the Shanghai and Shenzhen stock exchanges, we see that it is still undergoing structural changes to give more representation to the new economy (stocks that belong to the consumer discretionary, consumer staples and information technology sectors). Smaller companies and consumer trends can be good alpha generators. Skilled investment teams can exploit these to their benefit.
A focus on corporate governance can also generate more alpha. In China, corporate governance issues such as financial reporting, disclosures, and accounting standards are not high on many companies’ radar. These issues obscure where potential alpha may lie within the A share market.
Diligent active managers that establish good rapport with investee companies should get a better picture of how a company is expected to perform. They can also unearth companies with good practices that will likely keep them out of regulators’ crosshairs. We believe that having in place a robust set of due diligence processes will help managers uncover more attractive names to invest in, thus generating alpha.
Overall, there’s a common theme that run through all these approaches – active managers that have strong expertise on the ground will be able to uncover valuable companies that are likely to add strong alpha to returns.
What are the risks?
However, there are still some uncertainties when pursuing a fundamental-based active investing approach to China A shares. There are the usual risks of investing in emerging markets like China. We also note that there are other unique challenges that investors may face when looking at Chinese markets.
Policies and regulations may change fast or suddenly as China reforms and liberalizes its financial markets. For example, recent clampdowns on shadow banks, gaming companies, drug-makers and even kindergartens have put immense downward pressure on the share performances of listed companies in these sectors. Also, initiatives such as Stock Connect and Qualified Foreign Institutional Investor (QFII) – main channels through which foreign investors invest in China A shares – are still new and may see further tweaking to how they operate.
Listed companies also are allowed to suspend trading of their own shares, and companies have been known to do so on a very weak pretext. Sometimes, suspensions can go on for months. The Chinese Securities Regulatory Commission in November 2018 had introduced a series of guidelines geared towards improving the situation. We view this as a positive step as China looks to institutionalize the A share market even more, and to attract more foreign investors to the market.
For now, the A share market is still keeping on its track towards a higher level of sophistication, albeit at a slow and measured pace. This gradual transition from being retail-led towards more institutionalization is a good window of opportunity for skilled managers to capture strong alpha with greater ease than before. This means that investors and fund managers that are early movers and have experience on the ground can find attractive names to uncover in China’s A share market.
But we stress that even though a fundamental-based approach can help savvy stock pickers to outperform competitors, its true value lies in its long-term prospects: the A share market will continue to evolve and mature. This means that ultimately, it is the active managers that have the acumen, skills, resources and deep on-the-ground expertise that will be able to constantly uncover the true value of A share names. This way, they can uncover ample opportunities to generate good active performance.
The value of investments and any income will fluctuate (this may partly be the result of exchange rate fluctuations) and investors may not get back the full amount invested.
Kevin Chen is Chief Investment Officer at Invesco Great Wall, which is a 49% Invesco-owned joint venture.
1. Data taken from Morningstar between July 1, 2014 to June 30, 2019. Accessed on July 26, 2019
2. “China to transfer state assets to pension fund in bid to boost shortfall“, Reuters, published Nov. 18, 2017.
3. “Exclusive: China’s Social Security Fund Chief Lou Jiwei Retires“, Caixin Global, published March 26, 2019, accessed on June 4, 2019