We’ve all heard of the duck test: If it looks like a duck, swims like a duck, and quacks like a duck, then it probably is a duck.
It’s a form of abductive reasoning we should all consider before we invest – if everyone is telling us somewhere known for uncertainty and bouts of significant volatility is “the place to be in 2021” it’s probably a reason to be very cautious.
That was the case for Chinese equities 12 months ago. Having recovered remarkably well from the challenges of the pandemic, the outlook for the economy going into 2021 never looked stronger – unfortunately that has not been borne out in returns.
Market hit by government flexing its muscles
Chinese shares have actually fallen 26% since mid-February* with the Chinese government flexing its muscles in a number of sectors – volatility and government intervention is nothing new in China, which brings me back to those ducks!
The most newsworthy events this year started with a sudden and sweeping overhaul of the after-school tutoring industry. Companies in this sector were basically banned from making profits, raising capital overseas or going public.
The property sector then came under scrutiny. For some years, the Chinese government has been trying to wean property developers away from excessive borrowing. And now a myriad of new rules has hit companies harder than expected. Tech has also suffered, with fears of innovation coming faster than legislation – with some of the major tech players seeing their share prices fall some 35-50%.
The result, once again, is uncertainty and volatility – two words no one likes to hear when they are planning to invest. Unpicking China has never been straightforward, but the recent moves by the government have made it as hard as ever.
From the outside looking in, it appears they are becoming hostile to entrepreneurs and profit markets – but you could argue the underlying growth story remains in place with the country reducing longer-term economic and societal risks, with the aim of fostering a more sustainable growth agenda. My own view is that there is an opportunity, given the 25% fall seen in Chinese equities since February – if you understand the corporate risks, you can see the potential long-term gains given the strong tailwinds.
Growth of A-shares
However, I can fully understand why investors are wary. Which brings me to A-shares – an area of the market investors will increasingly have to consider as they will become central to the Chinese stock market in the near future. They currently make up 11.5% of the MSCI China, but that is set to rise to 40% in the next five years.
If we accept the volatility there are a number of benefits, not least that they are significantly uncorrelated to other global markets. In fact, China A-shares have only 0.32 correlation with global equities in the last 10 years (on a scale where 1 is fully correlated and 0 is completely uncorrelated)**. This means that A-shares move in a different direction to global equities almost 70% of the time. Contrast that to US equities which have a 0.97 correlation to global equities**.
The above is exactly what investors look for in times of uncertainty – such as we saw during the sell-off in 2020 – and when markets are looking fully valued, as they currently are. Interestingly, A-shares were also less affected by the recent clampdown by the government on the large tech and education firms, which are often represented in the Hong Kong-listed stocks and US-listed ADRs (American depositary receipts). By contrast, A-shares tend to feature companies in sectors like industrials, healthcare and consumer goods. That continued performance has been recognised with global investors net buyers of Chinese A-shares for nine consecutive months to the end of August 2021**.
There is also the diversity of returns from a sector perspective within the A-shares market – with a consistent rotation of top performers underlining the market depth**.
A-shares are still a relatively new story to retail investors in many parts of the world, yet they currently account for 11% of the world’s market-cap at the end of 2020 (expect that to increase). As with China itself, the risks are clear and there will be volatility, but the long-term argument is exceptionally strong. In 2020 foreign ownership of China A-Shares stood at 4.7% while their representation in the MSCI AC World Index stood at a nominal 0.6%***. So, it is still early days. Ultimately, if you invest in China in the future, you’ll want exposure to the A-Share market.
Funds to consider
Those looking for access to the A-Share market may want to consider the Allianz China A-Shares fund, managed by Anthony Wong and Kevin You. The fund aims to return 3-5% per annum over the index, over a market cycle and gross of fees by investing some 50-70, predominantly large, Chinese companies.
Others to consider include the Invesco China Equity fund and the Fidelity China Special Situations trust, with the latter currently having almost a quarter of its exposure in China A-shares***.
*Source: FE fundinfo, total returns in sterling for the MSCI China, 17 February to 18 November 2021
**Source: Allianz – 7 reasons to stay invested in China equities
***Source: Provider factsheet at 31 October 2021
