More institutions segregating China A shares

Institutional investors increasingly are splitting out China equities from their emerging market equity allocations to gain more exposure to alpha opportunities and better manage environmental, social and governance risks.

Global allocators from Europe and Australia recently have created dedicated exposures to China A shares, despite the increasing weight of China shares in major emerging market equity indexes.

In June, FTSE Russell completed the first stage of its China A-share integration into its FTSE Emerging All Cap index, increasing China's weight to 6% and adding 1,051 new large, medium and small-cap companies. Starting in 2018, MSCI Inc. began to include China A shares in its MSCI Emerging Markets index. The index had more than 1,500 China A shares, which constituted 5% of the index, as of Aug. 30, alongside a 37.4% exposure to China through the offshore market.

However, FTSE Russell announced Dec. 4 that it will remove eight Chinese companies from its global and China A indexes in response to a White House order banning investments in Chinese companies deemed to be supporting the country's military. The action will take effect Dec. 21, following the FTSE Global Equity Index Series quarterly review, and more companies could be removed at a later date.

The MSCI China A Onshore index gained 23.4% year to date to Oct. 30 and 3.9% over the last three years annualized. The MSCI China A International index delivered 24.7% year to date and 5.4% in the last three years annualized. Meanwhile, the MSCI Emerging Market index added 0.87% year to date and 1.94% over the three years annualized.

Investors cited China A shares' outperformance over broader emerging markets as one of the motivations to create separate China portfolios.

Sources added that China's economy is expected to surpass the U.S. as the world's largest economy by 2030. For long-term global investors, that outlook is expected to create opportunities. Domestically, they view China as an inefficient equity market dominated by retail investors — and one where institutional investors using active strategies can find alpha.

China has also proven to be a safe haven among other emerging markets.

"We had a massive global financial crisis this year and Chinese equities, bonds and currencies didn't sell off in a way that other emerging markets did sell off. When people get scared, they want to sell emerging markets," Jan Dehn, global head of research at Ashmore Group PLC in London, said in a telephone interview, adding that getting into the global indexes has helped China continue to execute its long-term efforts to attract foreign capital.

Willis Towers Watson PLC's research published Nov. 30 showed that Chinese risk assets should account for 20% of global investor growth portfolios over the next 10 years, compared with the current average exposure of 5%.

Investors said they are creating separate China equity allocations to diversify their portfolios and generate alpha. At the same time, they added that a standalone portfolio gives them a better understanding of country risk as well as a better understanding of specific ESG challenges faced by companies in China.

The £45 billion ($59.9 billion) Border to Coast Pensions Partnership, Leeds, England, allocated between £300 million and £500 million in October to a new, separate China portfolio run by UBS Asset Management U.K. Ltd. and FountainCap Research & Investment Co. Ltd.

The partnership had been managing its emerging market fund internally. That internal team will continue to manage the ex-China portion, said Graham Long, Leeds-based head of external management at the pool of local authority pension funds. With the restructuring of the emerging markets allocation, he said the pool in effect will have three "sleeves"— a global emerging market ex-China allocation and two new sleeves run by the two managers. Regarding the motivation behind splitting out China and outsourcing the running of the allocation to specialist managers, Mr. Long said that China as a portion of the emerging market universe is increasing.

China has increased from 35% to 45% of major emerging market benchmarks this year, he said. Part of that move was because of the A-share increase in wider emerging markets indexes, he said.

"We haven't reached a stage where the proportion of China market cap is fully included, there is still somewhere to go," he added. China's weighting in the MSCI benchmark is anticipated to reach between 53% and 55% of the index when onshore China is fully included, consultants said.

Another factor contributing to the decision was the fact that the Chinese government managed to contain the coronavirus better than other emerging markets. "If you look at the COVID-19 impact on emerging markets, China got COVID under control," he said.

State Super, a A$44 billion ($32.5 billion) superannuation fund in Sydney, which is a trustee for the State Authorities Superannuation Scheme, State Superannuation Scheme and Police Superannuation Scheme, took a different approach when it awarded a new China equities mandate to Ninety One PLC in October. "It is a sizable mandate," said Charles Wu, acting chief investment officer of the fund, adding that the fund added the new strategic allocation alongside its broader emerging markets mandate.

He didn't disclose the size of the new strategic allocation. "We have identified that the market is fragmented and as a result it's a better opportunity set for active managers," he said.

For State Super, an all-China allocation is also a better way to understand risk. "The appointment allows us to have a specialist manager that (can) take some of the issues specifically related to ESG into account in more detail," said Andrew Huang, senior investment officer for equities at State Super in Sydney.

An allocation to domestic China shares is a portfolio diversifier and also a market with fertile ground to add alpha, he added. Mr. Wu added that the opportunities in broader emerging markets and all-China shares are complementary to each other, although fund executives will evaluate the situation on an annual basis and as the market evolves.

It's also "possible" that emerging markets as an allocation will become redundant in the years to come, he said, as China increasingly dominates the indexes.

Betting on emerging opportunities in the China domestic market — for example, in clean energy — is APG Asset Management, the in-house manager of Stichting Pensioenfonds ABP, Heerlen, Netherlands, which has €462 billion ($552.7 billion) in assets and invests in China with E Fund Management Co. Ltd.

Rene van der Zeeuw, managing director, emerging markets equities at APG Asset Management, said the firm currently invests €900 million via a separate China allocation through a concentrated portfolio of 26 companies listed on the Chinese domestic market. That allocation was funded from its €44 billion emerging market equity allocation, which also is managed in-house and retains an exposure to China.

Mr. Van der Zeeuw said that APG could increase its standalone allocation to China even more in the coming years. "It's a specific market (where) institutional investors' participation is low," he said.

Simply relying on a external manager to gain China exposure through an active emerging markets portfolio may not be giving investors the allocation they want to the domestic market, sources said. Paul Colwell, head of the advisory portfolio group for Asia at Willis Towers Watson in Hong Kong said: "Many of the emerging market managers tend to be quite underweight in China. Most emerging market managers play the Hong Kong offshore market. Dedicated China managers tend to focus on the mid-cap (domestic) space."

Still, Mr. Colwell said that a separate China onshore portfolio should feature multiple managers. "You can get access to really nice alpha, but it is volatile. The gap between the best and the worst (managers) over the last 10 years, could be more than 10 percentage points per annum," he said.

As investors are stepping up their ESG investment processes, they are confident that standalone portfolios can actually help manage ESG risks in China according to their responsible investment policies.

Mr. Huang said that the new capability helps State Super to navigate ESG risks specific to China. Ninety One's ability to stay on top of the latest ESG trends helps with company engagement for the "cases where there are controversies that have to be actively managed," he added.

"We do ask quite frequently what the manager intent is (when it comes to ESG)and how they deal with it at a portfolio level," he said.

Border to Coast's Mr. Long agreed that ESG is a challenge due to the scarcity of company disclosure. Still, he said: "I don't think China is different to other emerging markets."

APG's Mr. Van der Zeeuw added: "We know we have to work hard in China to find good companies that fulfill (our) profile. That does not mean that we (lower) our standards when we invest in China. We are as critical about a Chinese company as about companies in developed markets." He added that APG considers the willingness of Chinese companies to start disclosing as a factor in its stock selection process.

Kathy Kejia Xu, senior portfolio manager at APG in Hong Kong, added: "The companies in our portfolio have the potential to improve."

APG scores companies based on its own scorecard developed for its emerging market investments and most of its Chinese investments have average scores.

"When we don't agree (with a company's practice), we would vote against the company (in meetings). Chinese companies have gotten used to more foreign firms in the market and the criticism, for example, on carbon issues because the top government in Beijing has a high target to go green (by) 2060," she said.

Hazel Bradford contributed to this story.