Opportunities in China will outweigh concerns

China's economy is now the world's second largest, and the greater China equity market — comprising mainland China, Taiwan, Hong Kong and Macau, at approximately $6.1 trillion in market capitalization — already has surpassed Japan's as the world's second biggest.

Yet, exposure to China equities by U.S. mutual funds stands at only $100 billion as of June 30, as estimated by EFPR Global. This represents just 0.0008% of the estimated $12 trillion in U.S. mutual fund assets and a mere 0.016% of the $6.1 trillion China equity market.

There are valid reasons for the lower representation of China equities, to date, in the MSCI All Country World and MSCI Emerging Markets indexes, two major benchmarks on which many U.S. pension fund allocations are based. Both benchmarks are constructed primarily based on market capitalization and the historical free float. The MSCI ACWI and Emerging Markets indexes exclude a material portion of the China equities opportunity set — mainland Chinese equities, or A shares. China A shares represent the largest Chinese equity market with more than 2,000 active companies and more than $3.5 trillion in total market cap.

China, historically, severely restricted foreign investors' access to A shares by imposing a quota on the amount of shares available to qualified foreign institutional investors. This allowed China to maintain tight control on capital flow and regulate cross-border securities investment.

As a result, investors pegged to both indexes typically have missed out on more than 50% of the greater China equity opportunity set.

This trend is beginning to reverse as the demand for foreign institutional investors entering the Chinese market continues to increase with the expansion of China's economy and growth of China's capital markets. The Chinese government has indicated its intent to further promote stable development and open up China's capital markets by attracting overseas long-term investments that can create value. During the past six months, Chinese authorities have raised the QFII quota by $50 billion to $80 billion. We anticipate further easing in the months ahead and, as a result, China equity allocations and QFII applications by foreign pension plans are expected to increase.

We believe the additional access to China A shares comes at an opportune time for investors. From 2008 to 2011, the China A share market measured by the CSI 300 (a cap-weighted index designed to replicate the performance of 300 stocks traded on the Shanghai and Shenzen stock exchanges) has declined more than 56%. During that time, real GDP in China increased 44% and total earnings growth for listed companies in the China A share market rose approximately 80%, with a compound annual growth rate of 15.8%. With 12-month forward price-earnings ratio at 8.8 for the MSCI China index and 10.5 for the CSI 300, valuations are now at historical lows and the opportunity for bargain hunters has expanded. The current trailing 12-month p/e ratio is 9.2 for the MSCI China index and 12.2 for the CSI 300, among the lowest ratios during the past 10 years.

China's long-term economic growth will likely be driven by the gradual balancing of regional disparities, as higher growth is expected in China's Central and Western regions.

Currently, there is a huge economic gap among China's different regions. For example, 2011 GDP per capita in the Tianjin province (in the East) is more than five times that of the Guizhou province (in the West), but recent GDP growth in the Central and Western regions significantly exceeded growth in the East.

Furthermore, infrastructure spending growth, as represented by fixed asset investment expansion, in China's Central and Western areas has continued to outpace the Eastern part of the country, with average FAI growth of 31.2% and 30.3% for Central and Western regions, respectively, over the past three years, compared with 23% in the East. Domestic consumption in Central and Western China also has lagged the Eastern region historically, but the trend has reversed as average retail sales growth in the Central and Western areas has surpassed Eastern China in recent years. With the central government continuing to develop the Central and Western parts of China, and narrow the economic disparity with the East, China's overall economy should benefit in the long run.

Over past 10 years through year-end 2011, the China equity market indexes have had low correlation to other major global equity markets. The average correlation of the MSCI China index and Shanghai Composite index against other developed markets is 0.58 and 0.27, respectively, compared to an average of 0.73 among developed markets. China equity markets, meanwhile, have generated stronger long-term attractive returns compared to other major global markets. The MSCI China and Shanghai Composite indexes have returned 214.35% and 33.62% respectively, over the past 10 years, compared with gains of below 10% in aggregate in the U.S., Europe and Japanese equity markets.

To conclude, U.S. pension funds historically have been underexposed to China equities because of the country's its lower representation in global equity indexes as well as the inaccessibility of domestic equity markets to foreign investors. In addition, governance, accounting issues and lack of transparency in Chinese companies are general concerns for overseas institutional investors.

We believe China's future economic growth is driven in part by balancing of regional disparities, and in our view, the current attractive valuation of the China equity markets will create opportunities that outweigh the challenges. n

Yulin “Frank” Yao is senior portfolio manager and Ria Nova is portfolio specialist at Neuberger Berman, Hong Kong.