China, Explained series: Hedging portfolio risks in China has more ways than one

China, Explained series: Hedging portfolio risks in China has more ways than one

Finding ways to hedge portfolio risks in China is perhaps one of the biggest challenges for global asset allocators, CIOs and institutions. A key concern for international investors remains a lack of breadth in financial products in China’s equity markets.1  We explore the ways global investors can hedge and mitigate portfolio risks in China.

The derivatives market in China becomes bigger and wider

As China opens its financial markets to foreign investors, the need for hedging tools, futures and options has increased, driving the development of China’s derivatives market.

The China Securities Regulatory Commission (CSRC) announced reforms to the Qualified Foreign Institutional Investors (QFII) and RMB Qualified Foreign Institutional Investors (RQFII) schemes (“the Measures”) which included the expansion of foreign access to China’s onshore derivatives market that came into effect on 1 November 2020.2

Measures to expand the QFII/RQFII schemes for derivatives include: 
  • Added financial futures contracts listed and traded on the China Financial Futures Exchange
  • Added commodity futures contracts approved by CSRC
  • Permitted options listed and traded on exchanges approved by regulators
  • Permitted foreign exchange derivatives approved by the State Administration of Foreign Exchange (SAFE).
Hedging portfolio risks in China is now different than before

Traditionally, portfolio managers in the past used the vanilla futures or options linked to China stock indexes to hedge volatility in their equity portfolios. Today, China has five domestic derivatives exchanges with trading volumes on the rise.3

The range of China A-shares hedging instruments available for equity investors:

Offshore hedging instruments: 

  • Equity index futures contract
  • Leveraged and inverse exchanged traded products

Onshore hedging instruments: 

  • Index futures for China stock indexes
  • Derivatives for index ETF

Source: Bloomberg data as of 27 January 2021.  

The updated QFII measures also allow margin trading, securities borrowing and lending which may improve market efficiency when hedging a short trade. (Refer: How margin trading and short selling work in China)

The wider availability of hedging instruments in China’s onshore market has been instrumental to the growth of relative value strategies and hedge funds in China, which typically seek to minimize market risk by taking offsetting long and short positions in related stocks and other types of securities.

Using factor rotation and other ways to mitigate risks

On the overall market risk, an effective hedging strategy can help reduce portfolio volatility or minimize the impact of a drawdown caused by beta (systematic) exposure to the broader market.

From a portfolio construction perspective, we believe mitigating factor risks can impact investment returns and make a difference to effective hedging. We observe that the performance of factors (e.g. Size, Value, Momentum, Volatility, Quality) tend to coincide with the stages of each business cycle. A portfolio that is highly concentrated or tilted towards a certain factor may risk higher volatility or sharp drawdowns. Investors sometimes chase market trends creating a crowded exposure to a major risk factor such as Size, Value and Momentum. The drawdowns from these crowded trades can be severe if the market trend reverses. Portfolios that can rotate factors in a timely manner between business cycles can potentially reduce drawdowns for funds during periods of market reversals.

When constructing portfolios, we find using risk limits can help reduce the impact of an unintended concentration to a certain factor, that may not warrant such high levels of risk. It can also help lower the correlation to / or limit exposure to certain risk factors and mitigate volatility in portfolios.

Key market risks in 2021 that investors need to consider

Disruption to the economy due to COVID-19 remains a key risk for global financial markets, as well as geopolitical risks if US-China bilateral relations remain uncertain. China’s equity market is more sensitive to domestic policy influence than external macro factors. These policy risks include: 1) changes to monetary policies which affect the liquidity in the market, 2) economic policies play a large role in driving industry risks (e.g. electric vehicles, 5G technology), 3) regulatory risks can also affect various industry and stylistic factors too. For example, tighter oversight on fintech and internet companies can affect the performance of value vs. growth styles.

One technical risk for investors would be the potential reversal or narrowing of the valuation gap between cyclical vs. growth sectors. As the economy gains momentum, valuations of cyclical stocks may catch up with growth sectors.

Preparing portfolios for uncertain times

In the last decade, China’s derivatives market has evolved to encompass a wide scope of financial instruments. Global economies were tested with an unprecedented crisis last year, serving as a reminder to investors that hedging risks and downside protection for portfolios is crucial in an uncertain and dynamic world.

Investment risks

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.

When investing in less developed countries, you should be prepared to accept significantly large fluctuations in value.

Investment in certain securities listed in China can involve significant regulatory constraints that may affect liquidity and/or investment performance. 

1 Invesco. The China Position (September 2019).
2 Lexology. China integrates and further liberalizes QFII/RQFII schemes (26 September 2020)
3 Emerging Market Views. The Evolution of China’s Commodities Markets. (21 January 2021)