Download paperof Chapter four: What’s your next move in China investing?
Surprise checkmate by stacked cannons
Alternatives
While Chinese stocks and bonds continue to present compelling investment opportunities, China is no longer just all about traditional asset classes, or even onshore versus offshore investments. In its pursuit to become one of the main global financial hubs, over the last few years China has actively focused on reforming its financial sector, and we believe that this is creating opportunities for relative value trading that weren’t available to investors in the past. China’s markets are becoming a key source of alpha and its transition from beta to alpha is one of the key trends in relative value investing at least over the next 5-10 years. There are at least three market characteristics and developments that are supportive of a more relative value approach to investing in China.
First, high retail participation and relative underinvestment by international and institutional investors—especially in A-shares—provide interesting entry and exit points as well as the ability to trade around that high market turnover for relative value investors. The dominance of retail investors creates dramatic swings in momentum and valuation skews, which can present unique alpha opportunities for relative value investors on both the long and short side of portfolios. The A-share market has had very low correlation to the offshore market, as it is driven by its own dynamics and is also extremely liquid, allowing institutional investors to trade sizable amounts with ease. While the influence of institutional investment capital is growing, we think it will take years for it to overtake retail investors as a key market driver. As we see it, this imbalance creates a compelling window of opportunity that active investors can seek to exploit.
Second, low coverage by sell-side analysts means that not much information is widely available, which is conducive for alpha generation from both the long and short side (Chart 5). Most of the A-share companies are minimally covered by analysts compared to the much higher level of coverage of other major markets. Additionally, only a small portion of A-share companies have English language research coverage—which means that the visible opportunity set for global investors remains small.
Chart 5: Listed company equity analyst coverage: China's equity universe is under-researched
Source: Reuters Elkon; UBS HFS, as of April 2021. Universe is based on companies with >=$500m market cap and >=$0.5m average daily turnover. Universe is based on stocks listed in Japan, China and United States, countries within MSCI AC Asia, countries within MSCI AC Europe.
Chart 5 - This chart shows that China A-shares are minimally covered by sell-side analysts compared to the much higher level of coverage of other major markets.
And last but not least, the use of short selling as a risk management tool to protect long positions has historically been limited by the availability of short borrowers in China. However, last year’s implementation of the new rules to improve liquidity through opening the Chinese capital market allows active long/short investors to reach out to domestic investors such as domestic mutual funds, life insurance companies and corporate investors. This has doubled the size of the borrowing pool and could mean a five times growth for the relative value market when it matures in the long term according to our estimates. These regulatory reforms will fundamentally change the operating characteristics of the China A-share market by allowing hedge fund investors to short with domestic brokers and secure margin on a range of securities that were not available in the past. Hedge funds will therefore be able to more effectively capture long and short alpha while dynamically managing beta, sector, factor, thematic and idiosyncratic risks.
We believe there is a large investment opportunity in China as liquidity improves on both the long and short side. We are also looking at quantitative strategies in China and are closely studying their credit and fixed income markets. These strategies may bring about much more efficiency and allow us to invest in a much more diverse way across the onshore Chinese equity markets. Investors who are bullish on China yet weary of short-term volatility should consider adding long/short strategies to their allocation.
The Chariot can go far and wide
Conclusion
China is a country of many strengths and potential, and offers plenty of attractive long-term opportunities. While it’s clear that risks to investing in China have risen and recent events have many investors on edge, we firmly believe the long-term investment case for China is intact.
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