Commentary: Alpha — made in China

A year ago, we wrote in Pensions & Investments about China A shares, seeking to debunk a few misconceptions and argue for broader investor participation in Chinese equities. A great deal has happened since then, with China the focus of global attention firstly as trade tensions with the U.S. became increasingly fractious, then as the eye of the coronavirus storm. As China emerges from lockdown, we thought it an opportune time to revisit our thoughts.

Our key message is this: Chinese stocks ought not to be thought of as merely another market; their overwhelmingly different performance dynamics offer such profound and persistent diversification benefits that they ought to be thought of as a separate asset class altogether. Global allocations to China remain low relative to the size of both the economy and its stock market. This is driven by a mixture of arbitrary exposure caps and outdated prejudices. We believe that this ought to change and Chinese stocks may offer significant opportunities for those wishing to extract alpha in an increasingly homogenized investment universe.

One facet of markets in recent years — both bull and bear — has been the increasing correlation between equities from different regions, and between equities and other asset classes. This increasing correlation has been driven by a variety of factors, from coordinated central bank activity, to globalization, to the increasing uniformity and sophistication of investment managers. China's idiosyncrasies — by which we mean its domestic-oriented fiscal and monetary policies, its largely retail investor base and its still largely isolated capital markets — mean that China A shares can potentially offer investors diversification benefits unavailable in other markets, as shown by the table below. This diversification has been so pronounced and persistent that we believe it argues for considering China A shares as a distinct asset class, rather than merely a new market.

This diversification benefit persists when we look at correlations between traditional 60/40 portfolios of equities and bonds, as illustrated in the graph below. It should also be noted that China exhibits inter-asset correlation dynamics more characteristic of what we traditionally saw in developed markets than emerging markets, with stocks and bonds largely negatively correlated over the past 15 years, offering the possibility of superior risk-adjusted returns. Indeed, over the last five years a 60/40 portfolio of Chinese stocks and bonds has delivered better absolute returns, and, in spite of materially higher volatility than other regions, a Sharpe ratio superior to either Europe or mainstream emerging markets.

At a time when investment managers are increasingly challenged in their attempts to generate alpha, Chinese markets may offer opportunities to gain an edge. More than 80% of trading volume in China is carried out by retail investors who are historically prone to behavioral biases such as herding. Inefficiencies that have been traded out of existence in more widely held markets persist in China. We looked at alpha across a variety of markets for a range of common quantitative strategies and found that the efficacy of these strategies decayed over time in every market but China, as illustrated in the graph below. While the continued institutionalization of Chinese markets ought to erode this inefficiency over time, we believe that there ought to be extensive opportunities for skilled investors to secure above market returns over the medium to long term.

Unlike many other developing markets, China's vast and growing e-commerce sector provides a rich source of data for quant funds to mine. According to analysis by Eagle Alpha, China is by some distance the leading global source of alternative data outside of the U.S., with as many datasets as Japan, India and Europe combined.

Given all this, the underrepresentation of China in global portfolios looks an increasingly costly omission. At the end of November 2019, MSCI implemented the third phase of its staggered inclusion of China A shares in its indexes, so that at the end of the first quarter 2020, Chinese onshore weights in the MSCI All-Country World index stood at about 55 basis points. By our estimates, foreign investors have roughly matched this exposure in their portfolios. The reasons used by MSCI to explain their weightings appear to us both arbitrary and unjustified. If foreign investors look beyond current benchmarks, the scale of underexposure relative to the size of the asset classes is gargantuan. Compared with potential Chinese benchmark weights of 12% for bonds and 4.5% for equities, we estimate that foreign allocations are underexposed by about $5.5 trillion.

It may be that the lack of genuine investor engagement with Chinese stocks is more about arbitrary caps, anachronistic index weightings and an outdated mindset than anything more fundamental. One way of challenging this situation is to consider investment in China not just as a move into a new geographical region, but a whole new asset class. We believe that Chinese equities offer significant diversification benefits to global investors and that there now exists sufficient breadth and liquidity in the market to argue for a much more prominent position in the global investment mix. The recent outperformance of Chinese stocks in the wake of coronavirus-related volatility wasn't just a facet of China's relative success in controlling the spread of the pandemic; rather it was illustrative of a deeper truth in our view: that in China they do things differently, and this is why their stock market offers such genuine diversification benefits, and the chance to generate alpha in a world where that opportunity is increasingly scarce.

Ziang Fang is a senior portfolio analyst and Ori Ben-Akiva is director of portfolio management at Man Numeric, Boston. Ed Cole is a managing director of equities at Man GLG, London. This content represents the views of the authors. It was submitted and edited under Pensions & Investments guidelines, but is not a product of P&I's editorial team.