Commentary: Solving the all-China strategic asset allocation puzzle

With China's weight in global equity indexes increasing and its markets maturing, U.S. investors — from institutions to high-net-worth individuals — are increasingly asking if they should consider a dedicated all-China allocation.

Today, most investors are underexposed to Chinese equities but there are several solutions, among them overweighting fast-growing domestic firms traded as A shares or modifying current emerging market allocations to better reflect China's improving prospects.

Before exploring how to change a strategic asset allocation to include an all-China equity carve-out, it's worth answering the question, "Why should investors consider changing their approach to China?" First, Chinese equity markets, once dominated by government-controlled companies, are rapidly improving. Today, markets spanning Hong Kong to China A-share exchanges and the new Nasdaq-like Shanghai Stock Exchange Science and Technology Innovation Board are more vibrant, reflecting a modern economy spurred on by small- and midsize public companies that are not government controlled, foreign investment, increasing capital supply and investment in such innovative sectors as biotech, artificial intelligence and 5G.

In addition, corporate governance has improved, capital markets are being developed to become more attractive to listing companies and investors alike, and the Chinese consumer is increasingly buying domestic brands. Crucially, China also has the tailwind of index providers such as MSCI increasing their China benchmark weightings.

Many investors still gain China exposure by tracking benchmarks — an approach we view as the wrong way to exploit the inefficiencies and potential alpha on offer in China.

As shown in Exhibit 1, MSCI Emerging Market index weightings heavily favor large-cap "offshore" firms — those traded in Hong Kong and in New York as American depository receipts — while having a negligible exposure to the faster-growing, domestic Chinese firms that trade as A shares. (That persists in other benchmarks too, including the MSCI All Country World index.) So, allocating to China by tracking benchmarks is akin to gaining U.S. equity exposure by overweighting megacaps at the expense of everything else.

China is already 43.2% of the MSCI EM index (as of Oct. 30) but as the free float of A shares increases and as market access continues improving, that dominance will grow, reducing portfolio diversification. The problem is even more serious when you look under the hood at the constituents of the index.

While the MSCI EM index already has the sufficient exposure to offshore China (38.4% as of Oct. 30), this allocation is heavily concentrated in a small number of megacap firms such as Alibaba, Tencent and Meituan Dianping (the top three stocks in the MSCI China index, collectively the "ATM" stocks) and many state-owned banks: That exposes investors only to a small piece of the full China opportunity set and leaves them underweight high-growth sectors, including consumer discretionary, health care and technology. At the same time, investors are sorely underweight A shares (4.8% of the MSCI EM index as of Oct. 30). With a growing number of fast-growing Chinese companies having their principal customer base tied to the domestic market and traded on A-shares markets, we believe passive index tracking makes little sense in the case of Chinese equities.

So, how can investors solve this conundrum? In talking with U.S. investors in recent years, three approaches are attracting interest.

1. Some investors, believing that China's importance and future prospects are not reflected in index weights, augment their allocations with additional domestic equities. Investors can maintain their current emerging markets allocation (already 43.2% China equity) while adding an additional allocation to China A shares to more appropriately balance the offshore/onshore opportunity. Precisely what amount of A shares investors might add depends on their long-term view of China.
2. Another approach is changing the emerging markets component of an strategic asset allocation. For example, using MSCI EM index weights on Oct. 30 as a baseline — a $100 emerging markets allocation comprises $56.80 of EM ex-China and $43.20 in China offshore and onshore — an investor could maintain $56.80 in an EM ex-China strategy while carving out the remaining $43.20 for an all-China strategy. Separating all-China from the overall EM allocation allows a portfolio to better reflect the China opportunity and solve for the existing lack of balance between offshore and onshore. This approach naturally includes a greater exposure to A shares and a has more balanced offshore exposure with a greater number of small- and midcap firms. Investors with a particularly constructive China view may decide on a larger all-China exposure than the 43.2% in the MSCI EM index.
3. Finally, some investors reduce their asset allocation within an ACWI ex-U.S. mandate or specific Asia-Pacific regional allocations to better reflect the growing important and influence of China from a capital markets and economic standpoint, especially within the Asia-Pacific region, by increasing the size of the all-China exposure.

These approaches are not mutually exclusive; investors can blend these options to both change their overall allocation to all-China and the constituents within that allotment. Whatever approach investors takes to creating an all-China allocation, they should consider the potential alpha opportunity in Chinese equity markets, which still have inefficiencies that can be exploited: Over the past decade, the median A shares active strategy outperformed the MSCI China A Onshore index by 8.2 percentage points, annualized, according to eVestment data as of Sept. 30. Meanwhile, the median manager only outperformed the MSCI EM index by 90 basis points annualized, while the median U.S. manager underperformed the S&P 500 index by 50 basis points annualized. So, for long-only equity investors, China offers a rare source of meaningful, sustainable alpha potential.

While the specific all-China allocation for any investor will depend on factors such as risk appetite and mandate restrictions, we contend that current China allocations fail to reflect the country's bright prospects and that investors should consider an all-China allocation beyond current benchmark levels. Less benchmark-sensitive investors sharing our conviction in China's improving outlook could consider an even larger allocation.

Christian McCormick is a senior product specialist covering China equity at Allianz Global Investors. He is based Denver. 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.