New research reveals investors are increasingly using dedicated China equity strategies for alpha generation, with the market turmoil of 2020 showcasing the country's diversification characteristics.
In the first quarter, the MSCI Emerging Markets index lost 23.6%, while the MSCI China A index lost just 9.72% and the MSCI China index (largely offshore) lost 10.22%.
In the survey, institutional consultant bfinance found that while four in five investors still use global emerging market strategies to obtain exposure to one of the world's fastest growing economies, the firm's clients are increasingly using dedicated China equity strategies like A-Shares funds or All-Shares strategies instead.
"This re-evaluation is partly driven by the growth of China's equity markets, both in terms of index weightings and overall market capitalisation," bfinance said.
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"It is also encouraged by rising awareness among investors of the different characteristics of onshore China equities, which are still very under-represented in global indices and global emerging market strategies."
Investors are also increasingly drawn to the ever growing universe of China-focused equity managers, bfinance said.
"There are now more than 60 A-Shares strategies, of which over 40 have track records of longer than three years," the consultant said.
More than 30 managers also offer All-Shares strategies, blending onshore and offshore capability. There are also 70 managers offering China equity strategies; primarily focused on offshore equities.
Similarly, index provider MarketGrader also believes there to be return potential from China A-shares. However, it argued that the key to boosting returns from Chinese equities is to limit investment in government owned companies.
"The paper finds that almost three quarters of all state-owned enterprises (SOEs) in China have a return on equity (ROE) below 10%," it said.
"As a result, 56% of companies in the CSI 300 Index, China's market benchmark index, had a ROE of below 10%."
Instead, MarketGrader recommends investors selectively pick companies using a "growth at a reasonable price" approach.
"Many would argue that the simplest way to outperform would be to exclude SOEs from an investment portfolio, but this is a blunt solution to a problem that requires a finer approach; especially because there are plenty of high quality SOEs in dynamic areas of China's economy which could prove beneficial for investors," MarketGrader chief executive Carlos Diez said.
Instead, the index provider recommends selecting discounted companies that are growing at a faster rate than the overall economy with attributes associated with sound capital stewardship and strong fundamentals.
Investors should identify "what we refer to as 'growth compounders,' or companies that we believe are the most consistent creators of long-term shareholder value," Diez said.
Meanwhile, bfinance recommends investors look to active managers for strong alpha generation.
"The average A-shares manager has delivered 5.3% per year over the last five years, versus -6.2% for the MSCI A-Shares index," it said.
"Meanwhile, the average 'China Equity' manager has delivered +5.3% per year versus +3.6% for their typical benchmark - the MSCI China index (90% offshore, 10% onshore)."
However, the consultant recommends investors look at the quality of each product and the extent to which strategies complement each other.
"bfinance notes the evolving relationship between onshore Chinese equities and global emerging market equities, which have historically demonstrated low correlation (0.53 over 10 years) but now appear - notwithstanding the divergence in Q1 2020 - to be more closely connected," it said.
bfinance senior associate Weichen Ding said investors can no longer ignore the potential of the Chinese equity market.
"It is increasingly untenable to remain on the sidelines of the world's second largest equity market," he said.
"More investors are beginning to take a strategic approach, as one might traditionally do with markets such as Japan, Europe and the US."
Similarly, VanEck head of investments Russel Chesler explained that although China was on track to becoming the biggest economy in the world, many Australian investors are still underweight Chinese equities.
"The Chinese economy is increasingly being powered by private companies in the sectors which make up the 'new economy' -namely healthcare, consumer staples, consumer discretionary and the technology sectors," he said.
"The companies in the index generally have a much higher ROE than most SOEs and lower levels of debt, so they are the ones investors should focus on for success in China.
These opportunities should not be missed, he said, recommending investors look to A-shares for exposure to China's new economy.