Foreign investors trim holdings of Chinese A-shares

Offshore investors have been the odd man out in China's domestic “A-shares” equity market for the past month or two, trimming their holdings as local retail investors were jumping in with both feet.

A measured rally that began there in July has shown hints of irrational exuberance recently, including:

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• a 25% surge for December, following an 11% gain in November;
• margin trading balances that almost tripled in 2014 to top 1 trillion renminbi (US$161 billion); and
• some aggressive forecasts, such as Morgan Stanley (MS)'s Dec. 5 call for gains of as much as 450% in 2015.

The recent spike in volatility — following years where the CSI 300 index of the largest companies listed in Shanghai and Shenzhen kept to a depressed range between 2,000 and 2,500 — has led to “a lot of profit-taking,” especially by offshore institutional investors, said Jack Wang, the head of sales for Hong Kong-based CSOP Asset Management.

Against the backdrop of a “liquidity-driven, retail-led bull market,” there were redemptions of US$4.9 billion in December from exchange-traded funds offering foreign investors exposure to China A shares, noted Wong Kok Hoi, founder and chief investment officer of Singapore-based APS Asset Management Pte. Ltd.

Even so, those managers, and others, predict a continued pickup in foreign allocations to China's quota-protected markets in Shanghai and Shenzhen for 2015, and a quantum leap should MSCI Inc. conclude the next annual review of its global index business in June by adding A shares to its emerging markets indexes — as many anticipate.

Ironically, the market's 63% surge to close the year at 3,533.70 came as a spate of sober economic data showed China's world-beating economic growth continuing to come off the boil — prompting retail investors to divert money invested in property or commodities to stocks, said Chen Li, Shanghai-based strategist for Greater China equities with UBS Global Asset Management.

Major factor

Analysts point to MSCI's decision last June to step back from a proposal to add an initial 5% of the A-shares market to its emerging markets indexes — amid asset owner concerns about quota-constrained access — as a major factor prompting China's Nov. 17 launch of a program giving domestic investors in Shanghai and overseas investors in Hong Kong unprecedented access to each other's markets.

The extent to which China's regulators “accelerated the process” suggests the priority they place on addressing the issues that have been keeping A shares out of those benchmark indexes, said Charles Salvador, director, investment solutions, with Z-Ben Advisors, a Shanghai-based consulting firm focused on investment management business opportunities in China.

Analysts say Chinese officials are looking for the inclusion of A shares in benchmark indexes to help make the country's domestic stock market more institutional in character, lowering the profile of retail investors more focused on short-term trading.

UBS' Mr. Chen said retail investors have been the A-shares rally's driving force, with their usual 80% share of trading volume likely edging above 90% in recent months amid the sharp pickup in margin trading.

Others note that domestic institutional investors were a contributing factor in the market's shift into high gear during the final months of 2014.

“It was very retail driven in the beginning, but domestically we've seen a lot of institutions start to participate as well (over) the past two or three months” — driven by policy decisions, including an interest rate cut and measures to help property companies finance themselves, said CSOP's Mr. Wang.

Short of bubble territory

Despite the market's more than 60% surge, market participants say A shares remain well short of bubble territory.

When the rally started to accelerate, the CSI 300 was trading on a 12-month forward multiple of roughly 10 times earnings, sharply below its historic average of 16.5 times, noted Calvin Wong, a Hong Kong-based portfolio specialist with Neuberger Berman Asia Ltd. focused on Greater China investments.

With the index above 3,350 at the start of 2015, the price-earnings ratio has rebounded to 14.8 — still “fairly reasonable,” said Mr. Wong.

Meanwhile, if foreign investors have been taking a chip or two off the table as the index surged, they remain too small a piece of the A-shares market to exert much of an influence.

Quotas for foreign investors from the qualified foreign institutional investor program China's authorities launched in 2003 and the renminbi QFII program added in late 2011, combined, come to US$115 billion — roughly 2% of the market's mid-December capitalization of US$5.768 trillion, said Mr. Wong. Even with market appreciation factored in, the weight of foreign investors should be well below 5%, he said.

For now, Chinese companies listed in Hong Kong — the freely traded H shares that already comprise the largest segment of emerging market benchmark indexes — remain the access point of choice for foreign institutional investors looking for exposure to the world's second biggest economy.

Still, the recent rally is making more foreign institutional investors look at A shares, even as there's a “huge debate” on “whether that rally is sustainable or not,” said CSOP's Mr. Wang. Expectations for rate hikes in the U.S., which could force investors to shift some of their equity holdings from U.S. stocks, is one factor leading them to look again at A-shares, he said.

In a Dec. 29 interview, Matt Whineray, the chief investment officer of the NZ$27 billion (US$21.1 billion) New Zealand Superannuation Fund, Auckland, said while his team is constantly evaluating all options offering exposure to China's economy, the surge in A-shares valuations makes that particular avenue less, rather than more, compelling.

Other investors — including the CIO of a Melbourne-based superannuation fund and the CIO of a Chicago-based corporate pension fund, who both declined to be named — cited further progress in areas such as transparency, corporate governance and unrestricted capital flows as preconditions to their considering A shares.

Still, money managers report a growing number of foreign institutions seeking more information about the A-shares market now, even as most remain on the sidelines.

Wang Qi, a Hong Kong-based executive director with MSCI and head of the firm's China equities research unit, said his team — in a paper released in November — contended that A-shares provide a degree of access to key segments of the China growth story, such as consumer-demand and health-care-related stocks, that investors can't get allocating money to the country's better known and widely accepted H shares.

While Shanghai's index was surging 60% in the past half year, Hong Kong's Hang Seng index was edging up only 1.2%.

Mr. Wang said China's domestic market has grown to the point where an investor will not be able to fully capture the long-term global equity risk premium without having exposure to A shares.