Malkiel's latest effort touts China strategies

Princeton University economist Burton Malkiel has his work cut out for him persuading U.S. institutional investors to move into all-China strategies.

But Mr. Malkiel, known for his book, “A Random Walk Down Wall Street,” is undeterred as chief investment officer of Baochuan Capital Management, Walnut Creek, Calif., a firm he founded with Kevin Carter, its CEO, and Mark Adams, its director of Research. (Baochuan is a Chinese word for treasure boat).

China-only investment strategies are a rarity in institutional investing, but Mr. Malkiel maintains “The Chinese growth miracle is only in the middle innings.”

Mr. Malkiel insists institutional investors are missing out on investing in the world's fastest growing economy; since the early 1980s, he says, China has expanded at more than 9% a year, after inflation.

“Neglect of China is a striking example of the lack of adequate diversification,” he says of institutional investor portfolios.

Most institutional investors have a 1% or 2% China equity exposure through Asia or emerging markets portfolios. That's low, Mr. Malkiel says, given that China makes up around 10% of the world's GDP. He argues institutional investors should have a minimum 5% exposure.

Many money managers offer China exposure as part of an emerging markets or Asia-only strategy, but offering a stand-alone China equity approach is unusual.

Among Baochuan's biggest competitors is Matthews International Capital Management LLC, San Francisco, which last October started offering institutional class shares in its two China-equity-only mutual funds, the Matthews China Fund and the Matthews China Dividend Fund. Matthews has $19 billion under management. Of that total, about $3 billion is in the China-only funds, with roughly $67 million of that from institutional investors.

Officials at Baochuan and Matthews say that while there's increased interest among U.S. institutional investors in China, major challenges remain in persuading them to accept China-only strategies.

Mr. Malkiel said one problem is that world indexes like the MSCI All Country World Index are free-float-weighted, meaning they only count shares of companies that are readily available to all investors.

Under that methodology, China only carries an approximate 2.3% weight in the ACWI because the index does not include Chinese A shares, which generally are only available to Chinese residents. (China has granted a limited number of licenses to foreign institutional investors that allow investments up to a set quota.)

Institutional investors are increasingly asking about China, but they are still more interested in broader Asia mandates with exposure to China, said Jodi L. Borkowitz, senior vice president at Matthews. “They are looking at the region first,” she said.

Ms. Borkowitz said that part of the issue regarding China-only equity investments is convincing consultants and investors that there is more opportunity than the index weightings reflect. For example, she said the MSCI China index is dominated by major banks and energy companies, leaving booming sectors driven by the rise of the middle class — like health care and consumer goods — less represented.

Still, Ms. Borkowitz said institutional investors are increasingly coming to Matthews to inquire about investing in China as well as Asia in general. Those inquiries led the firm to offer institutional shares in its mutual funds and, last September, to hire Kelly Holmes as vice president of client services to focus on educating institutional investment consultants on opportunities in Asia, including China.

Institutional assets in Matthews' funds, however, tell the tale that China-only investing is still a hard sell.

The $3.3 billion Matthews China Fund, an-all China equity fund, only has about 2% from institutional investors, and its $45 million Matthews China Dividend Fund has no institutional investors.

Mr. Carter, Baochuan"s CEO and chief investment strategist, said the key to changing the equation is educating institutional investors and consultants.

He said the exclusion of many China companies means indexes don't reflect that China is the world's second largest economy, trailing only the U.S. Mr. Carter also said China has been misclassified as an emerging market.

“We think it's a big enough market to deserve its own investment strategies,” he said. “Do we wait until China is the biggest economy in the world before we call it developed?”

Baochuan offers five China strategies. Three focus on Chinese companies trading on the Hong Kong and New York stock exchanges: growth equity; hedged long-only equity; quantitatively enhanced equity.

A fourth mandate uses a multistrategy approach investing in stocks on the Hong Kong and New York exchanges as well as in non-Chinese companies that have a major business presence in China.

The fifth invests in a diversified portfolio of non-Chinese equities that benefit from China's growth.

The institutional strategies are not new; they originally were part of AlphaShares, a money manager focused on Chinese investments founded by Messrs. Malkiel, Carter and Adams in 1996.

Part of AlphaShares' business was to develop and license China equity indexes for ETFs. Those ETFs had around $800 million in assets as of Dec. 31.

But its other primary business, developing institutional strategies for investing in China, got little traction, with only $35 million in the five strategies.

Baochuan was spun off from AlphaShares, Mr. Malkiel said, to put a single focus on selling the institutional strategies.

Some major pension funds have increased their Chinese equity investments in the past several years. The $220.3 billion California Public Employees' Retirement System, Sacramento, had $677.2 million in Chinese equities as of Sept. 30, according to spokesman Clark McKinley; just more than three years ago the country was on the system's banned list because of concerns about investment transparency and freedom of the press.

Still, CalPERS' investment is only around 1% of its $62.5 billion international equity portfolio. Mr. McKinley said the system is looking to increase its allocation to China but the retirement system most likely will keep any such investment as part of a broader portfolio managed by external managers. “It would be too risky to invest in one single country,” he said.

“The interest in Asia is being driven by the China story,” said David Ritter, senior vice president at investment consultant LCG Associates, Atlanta. But he said the limitations on foreign investments in Chinese companies calls for an alternate approach.

Mr. Ritter recommends a diversified approach that includes investing in Chinese equities but also in companies in countries such as Australia that are capitalizing on Chinese growth because of huge exports. LCG has $47 billion under advisement for pension plans, foundations and endowments.

Ultimately, increased investment in China might depend on a loosening of government regulations in the country, said Conrad Saldanha, managing director, and head of emerging markets equities at Neuberger Berman Inc., New York.

“China remains a policy-driven market and investors are concerned with the tightening measures, the lack of transparency and the domination of state-owned enterprises,” he said.

But Mr. Malkiel is sticking to his guns. Investing in Asian countries other than China, “is fine,” he said, but he maintains that China-only investments will produce the best returns. “China will lead the growth parade, as other markets such as Vietnam are just developing.” n