Aaron Costello
Answers to our clients’ questions about market action and the market environment in a few paragraphs every two weeks.
Yes, but only if you can tolerate the volatility. Chinese A-shares have surged in 2019, rising nearly 23% as of March 8. In 2018, A-shares’ -29% return was one of the worst among major markets, but renewed optimism this year over US-China trade negotiations sparked the sharp rebound.
Investors are also enthusiastic about MSCI’s February 28 announcement that it will further increase the weight of A-shares in their global indexes, following the initial inclusion in June of last year. 1 However, increased index representation on its own is not a compelling reason to purchase A-shares, given foreign inflows remain relatively small compared to the overall size of the market. News last summer of expanded index inclusion certainly didn’t trigger a rally in A-shares, and neither did MSCI’s late-February announcement as the market sold off last week.
Domestic sentiment and liquidity are the A-share market’s key drivers, and both have improved recently amid signs of a US-China “trade truce” and increased monetary and fiscal stimulus in China, as well as a dovish US Federal Reserve helping support the Chinese renminbi. Retail investors, who account for more than 80% of trading volume, drive the A-share market’s over-reactive shifts in sentiment. This results in higher market volatility, but also potentially more opportunity for managers to add value.
While the market is vulnerable to any disappointment in US-China trade negotiations, valuations remain below historical averages and any near-term selling may offer long-term investors an attractive entry point.
Despite the negative sentiment toward China, we believe long-term investors should take a more comprehensive and systematic approach to investing in China. Rather than delegating the China allocation to global or EM managers, investors should determine their own desired allocation level and consider adding dedicated China managers in both public and private markets. Further, the public equity allocation should incorporate domestic A-share stocks, either via an A-share mandate or an All-China mandate.
Such an approach entails determining the target allocation to China and actively monitoring the actual allocation across the total portfolio (including dedicated China managers, as well as regional or global EM mandates across asset classes). While there is no universally appropriate level of China allocation within a portfolio, we believe long-term investors should overweight China relative to its current weight in market capitalization–weighted global equity indexes. This conclusion is based on China’s underrepresentation in global benchmarks, the quality of the public and private manager universe, and appealing public market valuations, even after the recent rally.
If China is underrepresented in global benchmarks and portfolios, how much China do you need? Unfortunately, there is no easy answer. It is tempting to simply look at China’s share of global GDP (16%) and assume it is an appropriate target. However, we strongly advise against using such a heuristic, as there is no link between the size of an economy and its share of global capital markets or of investment portfolios. In fact, the US economy’s share of global GDP has been steadily declining (from 34.9% in 1985 to 24.1% today), but its share of global stock market capitalization has been rising and today stands at 54.4%, versus an average of 45.4% since 1980.
In the case of China, looking at the country’s share of global GDP overstates the size of the investable universe. At the same time, investors need to be aware that portfolios have both direct and indirect China exposure via global company revenues and other economic links to China. For instance, FactSet calculates that China accounts for 9.0% of MSCI ACWI company revenues, much larger than China’s current 3.6% weight in the index. Increasing direct China allocations without taking into consideration indirect exposure could result in portfolios becoming overexposed to “China risk” broadly defined. If investors are already meaningfully overweight EM or Asian assets (which have closer economic links to China), increasing dedicated China allocations may require scaling back existing EM or regional manager mandates, rather than simply adding direct China managers.
As a result, investors need to look holistically across the portfolio, including global equities, EM equities, hedge funds, and private investments. There is no magic number, but total portfolio allocations to Chinese assets of 5% to 10% seem reasonable, with some portion of this via dedicated China managers.
Aaron Costello, Managing Director on Cambridge Associates’ Global Investment Research Team
Footnotes
- On February 28, MSCI announced that it is further increasing the inclusion of China A-shares in the MSCI indexes over the course of 2019 from 5% of their investable market capitalization to 20%. Over the longer term, Chinese equities (both onshore and offshore) could account for 5.4% of the MSCI ACWI Index, assuming full inclusion of investable market cap.