Commentary: Finding a back door for long/short strategies in China

The past 18 months have not been kind to Chinese stocks. The MSCI China index slumped by nearly 19% last year, and while investors recouped some of their losses in the first quarter, shares have continued their descent since April.

The drubbing is justified: fears of a global recession (reflected in falling bond yields); the cascading impact of trade tensions (agonizingly, tweet by tweet), not to mention currency devaluations (as the yuan hit an 11-year low against the dollar); and the ongoing unrest in Hong Kong (paralyzing one of Asia's largest financial hubs) have all played a role in the weakness. But the collapse in equities in 2015 and 2016 was even worse, so volatility in Chinese equities is nothing new.

However, trying to avoid volatility by timing Chinese exposure is difficult to do. And those who do try to time the market are likely to miss at least a portion of the rebound. This is a lesson — after the 2015-2016 bottom — many learned when the MSCI China index was up nearly 55% the following year.

There is a better way: go long value, long momentum and long quality; focus exposure on secular trends in China and mean-reverting value trades; and, importantly, short the areas exposed to the country's heightened near-term risks and longer-term secular losers. It sounds easy. The catch is that long/short investing in China is more complicated than traditional approaches in developed markets, which creates advantages for those able to navigate the complexity.

Access to Chinese equities has always been far more circuitous than in most other geographies. Listed companies are categorized into A shares, B shares and H shares. A shares are composed of mainland companies that trade on local exchanges and denominated in yuan; B shares represent Chinese companies listed on mainland exchanges but traded in foreign currencies; and H Shares are listed in Hong Kong and denominated in Hong Kong dollars, without any restrictions as to who can and cannot trade the stocks or how they trade the stocks, short or otherwise. As it stands, traditional short selling of mainland companies remains confined to approved Chinese investors.

Regulatory obstacles create inefficient markets for issuers and investors, but don't prevent long/short traders from hedging China risk. The mechanics don't change, but without being able to short Chinese stocks directly, foreign long/short investors need to find adequate surrogates across the larger Association of Southeast Asian Nations region. Beyond the deep and liquid Hong Kong market, China's regional trading partners offer alpha-generating shorts that are also characterized by some of the associated Chinese macro risks. For example, a regional airline reliant on Chinese tourists may see passenger volumes decline due to geopolitical tussles or if Chinese consumers pull back.

Many long investors in China are positioned to reflect the country's transition from an industrial- to a consumer-driven economy. These holdings may include high-quality names in consumer-oriented businesses, ranging from e-commerce companies to local liquor brands and Macau-based casino stocks. Opportunistic portfolios will be weighted more heavily in the troughs, when valuations are most compelling, and are then trimmed as the market rallies and the stocks "re-rate."

Short positions, meanwhile, are exploiting China's ongoing transition away from low-cost manufacturing. Given the excess capacity in many of the investment-led segments of China's economy — think real estate, coal-powered electricity, steel and other commodities — these companies are showing signs of weakness, suggesting even current valuations remain optimistic. The risk will become more pronounced as Chinese manufacturers deal with rising wages, a scenario that could occur parallel to the newer challenges of a protracted and aggressive trade war.

Of course, with stimulus and a trade-war resolution, these shorts will rebound — the dreaded "junk rally" — to create a drag on performance. Analysis, thus, should focus on company fundamentals vs. macro-oriented bets, providing a margin of safety for both long and short books.

Without question, long/short investors would always prefer to execute short trades directly in a given geography. And China's market, characterized by a higher proportion of individual investors — with weaker corporate governance standards and wild swings in volatility — will one day present an ideal market for professional short sellers. In the meantime, the restrictions around short selling, particularly in Greater China, creates an advantage for professional asset managers with the scale and skill set to navigate the nuance. The tougher the trade is — operationally — the more it favors professional players with a scaled platform.

Ironically, in restricting short sales, regulators are overlooking the role of arbitrage to improve price discovery for all investors and support governance through a market-based solution to clean up and prevent corporate fraud. Short selling would add efficiency to what remains a less-efficient market. The significant premiums at which A shares trade to identical securities listed as H shares in Hong Kong, for instance, are a good barometer to measure progress.

Short sellers will still be cast as the scapegoats whenever the markets stall amid economic dislocations. This will be true whether the downturn can be traced back to some combination of poor public policy, exogenous shocks to the market, or a negative feedback loop from an overturning wealth effect. The optics of profiting from distress, even if the strategy contributes to a healthy and liquid market, creates an easy target for policymakers. Apparently, price discovery is not a public service. Experienced long/short investors, however, will continue to exploit the market inefficiencies that stem from regulatory overreach, while still finding a way to hedge against and capitalize on irrational behavior when and where it exists.

The journey is not without peril. A short book can be a significant drag on absolute performance in a bull run. Over a multiyear period, however, short selling can produce attractive risk-adjusted returns while providing some countercyclical and diversification benefits in choppy markets, be it in China or across the broader emerging markets. These benefits, if combined with thoughtful portfolio construction, will, on a prospective basis, create more optimal portfolios.

Paul Korngiebel, based in Boston, is lead portfolio manager on Boston Partners Global Investors Inc.'s emerging markets long/short equity strategy. This content represents the views of the author. It was submitted and edited under Pensions & Investments guidelines, but is not a product of P&I's editorial team.