China’s private sector is very fluid, made up of industries and companies that are very dynamic and a fast-changing competitive landscape. To accurately capture the alpha and manage risk in A shares requires devoted attention from active managers.
Concerns over dedicated allocations to A shares
Investors should also be aware of the risks and problems that may result from having a dedicated allocation to China A shares.
We've talked about the idiosyncratic risks that China A shares can represent. In a global emerging markets portfolio, a generalized risk model is applied across the board, and if China A shares are put into this same portfolio, a lot of these idiosyncratic factors will get buried and be overlooked. If A shares are behaving differently from other asset classes, investors won't be able to find out why within the global emerging markets portfolio.
Policy and regulatory risks are another major concern. The country is still opening itself up to foreign investments while ensuring stable economic growth and currency strength. This means that despite China gradually easing capital controls, the flow of capital still remains heavily regulated. Not only does that impact how much funds can investors repatriate, they can also result in volatility when investors expect a downturn in the near term.
These distinctive risks that China A shares present require a concerted effort at managing them, which would entail a targeted, standalone strategy to achieve the best results possible.
We stress that while a dedicated allocation to China A shares doesn't mean that risks would be lower, the approach would make the idiosyncratic risks more visible, allowing active managers to afford it the necessary attention.
The low quality of corporate disclosures, governance, and accounting standards are another source of worry that could make an investor think twice about allocating directly to A shares. However, we stress that these issues are not unique to China alone – many emerging markets also face the same problems. In fact, China has been taking steps to improve on these fronts. Though these issues remain a risk for investors, skilled active managers can help them mitigate these dangers.
There may be concerns over implementation. Investors that typically do not take on single-country mandates may find a dedicated China A shares allocation difficult to implement. At the same time, the lack of global ex-China indices means that those who choose to have an A-share-specific allocation may see some overlap with other allocations. However, we see this as teething problems that can be resolved as time goes by. More and more investors are likely to see the value of China A shares and will want to make dedicated allocations to them.
We've shown how a dedicated exposure to China A shares can help investors manage the idiosyncratic risks and reward that the asset class offers. An added benefit that arises from the standalone exposure, then, is the ability to capture higher alpha.
It’s worth noting that many of these benefits from having a dedicated allocation to China A shares are temporary – we think that they will weaken over the next five to 10 years. As their representation on global indices increases and as China allows more foreign money to flow into its stock markets, the correlation benefit will fade, and the market will become more efficient. Considerations in capturing alpha will subsequently change.
For now, despite the uptick in global interest, the market remains largely driven by retail investors. At the same time, macroeconomic and global uncertainty about China’s progress is sidelining a lot of investors. As China’s clout grows within the emerging-market pool, long-term investors who are early movers are more likely reap the full benefits from a dedicated China A share exposure.
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 Source: MSCI, Citi research, March 2019.
^2 Source: International Monetary Fund database April 2019.
^3 Source: The World Bank in China – Overview, World Bank website, accessed on July 5, 2019.
^4 Source: National Bureau of Statistics of China, accessed on July 3, 2019.