Quant strategies may become more mainstream

Chin Ping Chia, Head of China A Investments

Alexander Tavernaro, Senior Portfolio Manager, Invesco Quantitative Strategies

Andrew Tong, Senior Portfolio Manager, China A Investments, Invesco Quantitative Strategies

Chin Ping Chia, Alexander Tavernaro and Andrew Tong share their views about the Chinese A-shares market and factor investing in China.

Q: In light of the extraordinary events in 2020, what has changed about the China investment landscape?

Chin Ping Chia
In a year characterized by the global pandemic and US-China trade tensions, the A-shares market was among the best performing equity markets, supported by strong domestic investor sentiment and global capital flows. While traditionally, investment decisions have been driven mainly by index inclusion, China’s economic rebound and policy reforms have begun to take center stage in terms of allocation signals in recent years.

The most recent Invesco Global Sovereign Asset Management Study confirms the growing interest in Chinese stocks. Global sovereign wealth funds singled out China as the one market where their allocations were clearly increasing. Over 90% of large sovereigns, with more than USD 100 billion assets under management, indicated an exposure in China. Interestingly, close to four-fifths of allocations to China were cited as active decisions rather than benchmark driven.¹ And about 85% of these active allocations were long-term and strategic.

Alexander Tavernaro
Unlike Europe, China is still in a mid to high-growth stage of economic development. Its higher return potential is attractive for European asset owners, who need to optimize their allocations to meet increasing pension liabilities.

But, even though China is the world’s second-largest economy, its weight in global equity portfolios remains limited. As China is projected to overtake the US over the next ten years, more investors may opt for a stand-alone allocation to China to better reflect its idiosyncrasies. Many investment consultants even now advocate a greater allocation to China, not least because rapid deregulation of the A-shares market in recent years has greatly enhanced its accessibility.

Andrew Tong
2020 marked the 30th anniversary of the A-shares market, which traces its beginnings to the establishment of the current Shanghai Stock Exchange in 1990. The impact of the pandemic, as well as a wave of trade protectionism and political tensions, may have accelerated market reforms. As China embarks on economic transformation under the “dual circulation” model – strengthening consumption and the domestic economy – we expect the market to evolve even more quickly over the next ten years. Moreover, as experience from the US and Japan shows, capital market development and stability are often key drivers of mutual funds growth.

The current 14th 5-year plan spells out the importance of strengthening wealth management – don’t forget that China’s population is aging too. Together with the opening of China’s market to global investors, we believe this will drive steady market growth.

Q: How does all this affect quant investing in China? Are you seeing more opportunities or risks?

Chin Ping Chia
Quantitative investing in China has only started to gain a foothold in the last ten years, since enhanced index strategies based on systematic factor premia were introduced. Today, there are more than 300 mutual funds using quantitative techniques. Active quant or enhanced index products have more than USD 250 billion in assets under management. But that’s only a small fraction of the overall mutual fund market in China. There is clearly significant growth potential, particularly compared to other countries.

Andrew Tong
In my opinion, quant strategies could become more mainstream for a number of reasons. They are cost efficient and scalable, which makes them well-suited for a large and diverse universe like the A-shares market. Their natural advantage in handling large datasets can provide an edge in more quickly and effectively processing digitized information. And, as the market grows and matures, we expect investors will increasingly look for alpha rather than pure beta. Quantitative strategies that can deliver pure alpha or smart beta are likely to be in greater demand as time goes on.

Q: We often hear about the dominance of retail investors in the A-shares market. What is your view?

Alexander Tavernaro
Chinese investors have a strong domestic bias, often leading to a low correlation of Chinese stocks with the markets in the US and Europe. This creates diversification opportunities for global investors, more than many other emerging markets. But a large proportion of retail investors can also lead to overheating risk. Last year, however, activity was more subdued, which greatly alleviated investors’ fears of a new bubble.

Chin Ping Chia
Chinese retail investor behavior is well studied. We think that, with the right expertise and skill, the A-shares market can be one of the best alpha hunting grounds investors can find. Over the years, active managers in China have been able to generate outsized returns. From 31 December 2007 to 31 December 2019, even the median manager outperformed the benchmark (the CSI 300 Index) by more than 4 percentage points annually. Top quartile managers outperformed by over 12 percentage points per year.²

Q: What about traditional quant factors?

Andrew Tong
Interest is growing in quantitative investing in China, perhaps because institutional investors – both onshore and offshore – are becoming more sophisticated. Adjusted for differences in market structure, traditional factors such as Value and Size may be at least as effective in China as in the US, if not more so. In addition to the retail investor bias, there are significant regulatory effects. We’ve analyzed the Non-Tradable Shares (NTS) reform and phenomena like reverse mergers, and what they have meant for market behavior and factor performance. 

Alexander Tavernaro
Challenges arise when traditional factors don’t work as accustomed. This has been the case for the Value factor over the past decade, especially in developed markets. China may still be different, but that could change when its economy advances. Our recent innovations in natural language programming and artificial intelligence may then help to improve diversification of factor alphas.

Q: How do you deal with factors that are specific to the Chinese market?

Andrew Tong
Since we use structural growth as well as alpha opportunities, we have to distinguish between systematic and idiosyncratic risks. Our research in China was built from the ground up to avoid the pitfalls of over-extrapolating from the behavior of other emerging markets. For instance, even though a longer data history is generally good, data from before the NTS reform, which began in 2005, bear little relevance in today’s vastly different market.

Instead, we study various factors’ efficacy in different market segments – e.g. large caps vs. small caps. We examine factor rationales with the help of additional macro and market microstructure data. Especially in China, investors should not be afraid to challenge conventional wisdom.
 

About risk
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 (2020): Figure quoted is based on a sample of respondents to the study. Some 139 chief investment officers, heads of asset classes and senior portfolio strategists (68 sovereign funds and 71 central banks) were interviewed between January and March 2019 for the study. These investors are responsible for managing over US$20 trillion in assets (as of March 2019).
2 Source: Wind, data from 31 December 2007 to 31 December 2019. “Active Equity Funds” refer to all onshore China A active funds with over 60% in equity but excluding passive and quant funds, with more than 12 months performance history. Median and top quartile managers refer to managers who outperformed the 50th and top 25th percentile fund performance sample respectively. Past performance is not a guide to future returns.

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