Six reasons for a strategic active approach to investing in China  

We believe the scope for active managers to outperform in China is higher than in many other markets. 

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Six reasons for a strategic active approach to investing in China

There has been much to debate around investing in China in recent years. Macroeconomic concerns, regulatory uncertainty, and ongoing geopolitical tensions, among other issues, have given some investors pause for thought.

China is the second largest economy in the world and has the second largest population. GDP growth may be slowing, but China remains among the fastest-growing economies globally. In US dollar market capitalisation terms, China offers the second largest equity market universe in the world, behind the US. For many investors, it is hard to ignore.

In the wake of market weakness in recent years, and the various challenges facing the economy, international investor sentiment has been depressed for a long period. Despite the recent rally, valuations versus international peers remain close to their lowest in 20 years, and cheap relative to their own history. This has led many to wonder whether Chinese equities are a great opportunity or a value trap.

This paper is not to make the case either way for investors to be fully invested, or fully divested. Instead, we argue that investors should actively invest in China. Passive approaches are unlikely to deliver the exposures investors are hoping for, given issues of index composition, the presence of state-owned enterprises (SOEs), and ongoing universe evolution. We believe the scope for active managers to outperform is higher than in many other markets. 

Figure 1 and 2 , reasons to invest in China

Chinese equities have been very weak in recent years – but it hasn’t always been that way

As measured by the MSCI China Index, Chinese equities have declined 41% in US dollar terms since their pandemic peak from 17 February 2021 to 1 October 2024. This lags behind both developed markets (DM) and emerging markets (EM), which have returned 41% and -9% over the same period.

Figure 3 and Figure 4 show the performance of the MSCI China index relative to broader DM and EM over the past 20 years. China has underperformed in DM and is only slightly ahead of EM, and the volatility of returns has been markedly higher. Within this timeframe though, there have been periods of outperformance of Chinese equities. Moreover, the higher volatility can create opportunities for investors. 

Figures 3 and 4

We have so far referred to the headline MSCI China index, as it offers the longest performance track record. The past decade has seen China’s equity market universe for international investors expand to include the mainland markets of Shanghai and Shenzhen, as well as the offshore market (Hong Kong Special Administrative Region (SAR) and foreign-listed Chinese companies). Where appropriate, we refer to the MSCI China All Shares index in this paper as a reflection of the broader China opportunity set for international investors.

Why is an active approach crucial in Chinese equity markets?

1. There are cheap companies generating high returns on equity for investors – there are also cheap, low-quality ones. You can’t afford not to go active.

Figure 5

If markets were efficient, you might expect a relationship between how profitable a company is and its valuation. Not so in China. And inefficiency is the lifeblood of active investors. At a market level, Chinese stocks are cheap, and at an individual company level, in many sectors, there are cheap companies with strong fundamentals, representing potentially attractive opportunities. There are also cheap companies with weaker fundamentals, potentially representing ‘value traps’.

For example, Chinese IT companies are trading on a price-book of 3X with returns on equity (ROE) as low as 4% and as high as 28%, and financials trading on a price-book of 1x with ROEs as low as 1% and as high as 21%. Differences like this exist in all markets but our research finds evidence of a weaker relationship between valuations and ROE in China than elsewhere. For example, taking the MSCI USA as an example, the R2 value measuring the degree of variation in the price book ratio which can be explained by differences in ROE is 88% for consumer discretionary and 61% for IT. The equivalent figures using the MSCI China All Shares index are 45% and 13% respectively.

These inefficiencies provide a rich opportunity set for active investors. They also highlight a risk in simply ‘buying the market’ as this means investors risk ending up owning companies that may be cheap for good reason. Cheap valuations present an opportunity, but an active approach is essential.

2. A less mature market = potential for greater mispricing and opportunities for an active approach 

Figure 6

One reason for market inefficiency is the high prevalence of retail investors in China. In the US, around 70% of the market is owned by institutional investors. In China, it is about 10%. 

Retail investors can have shorter investment horizons, and potentially overreact to new information. This has historically contributed to higher market volatility in China. It can create higher stock dispersions, and move stock prices away from intrinsic values, creating opportunities for long-term active investors to add value.  

This is partly a function of the Chinese stock market being less mature (the onshore Chinese market is also less mature than the offshore Hong Kong market). It is also partly a function of China’s capital restrictions, which make it harder for domestic individuals to invest overseas and thereby encourage them to invest in the domestic stock market. The same also applies to domestic real estate.  

As the market matures, institutional participation is likely to rise. But that is likely to take some time. In the meantime, it presents an opportunity for active managers to profit from sentiment-driven price swings. 

3. Fundamentals matter in the long term and markets still look inefficient; this implies opportunities for active strategies 

China is often spoken about as being driven by retail flows and sentiment. And this is to some extent true (as we discussed above). But that doesn’t mean that fundamental analysis doesn’t work. Macroeconomic and regulatory uncertainty, as well as geopolitics, have contributed to some distortion in the performance of fundamental factors in recent years, but various factors have rewarded investors over the longer term.  

Figure 7 shows that the last ten years have seen various factors outperform the broader market, as measured by the MSCI China All Share Index, and associated factor indices. Stronger fundamentals, in terms of quality, in particular, have been rewarded over the long term. High dividend yield, enhanced value and momentum factors have also outperformed the broader market over the past decade. 

Figure 7
Figure 8

These charts highlight that various factors have been rewarded in the long term, supporting the case for active managers with a rigorous strategy to capture excess returns. However, taking a long-term approach remains key, particularly given some of the market characteristics, which we will come on to.

4. High dispersion of returns creates potential opportunities for active strategies

Figure 9

There is a much higher dispersion between stock/sector returns in China than in DM. This leads to greater opportunities for active managers to add value.

One way to see this is by comparing returns on the best and worst performing stocks in any given 12-month period. We do this by looking at the difference between the 95th and 5th percentile of the return distribution, to remove the effects of any outliers. On this basis, the average difference in China has been 121 percentage points over the past 20 years. In other words, if the 5th percentile returned 5%, the 95th returned 126%. This compares to an equivalent figure of 90 percentage points for DM; i.e. dispersion of returns in China is a third higher than in DM. On an equivalent sector basis, dispersion is twice as wide in China versus DM. The trend is similar for the mainland MSCI China A Onshore Index.

5. Another way to see the inefficiencies is in more limited analyst coverage 

Figure 10

As with other EM, the average number of analysts covering each company in China indices is less than in DM. Lower analyst coverage and few (in some cases no) long term forecasts can create an opportunity for active managers to add value. Figure 10 shows the percentage of companies with at least one analyst forecast for the next three fiscal years is above 90% in most EM and DM, including China. This falls sharply looking beyond three years in EM, and especially in mainland China A markets.

6. Depth, breadth, and evolution of China’s equity universe = opportunities for active managers 

Figure 11

China’s stock markets are large, sectorally diverse, and liquid (see appendix for greater detail on market characteristics). Mainstream indices today incorporate a greater proportion of the opportunity set than in the past, following MSCI’s decision in 2018 to start including Chinese domestic stocks (A-shares). But this still means there are many companies not included in these indices, especially smaller and mid-sized companies. And only 20% of the market capitalisation of eligible A-shares are currently included in MSCI China and MSCI Emerging Market indices. The index is a poor representation of the rich opportunity set.

Those investors who access Chinese equities by tracking the popular MSCI China index also unwittingly take on more concentration risk than is the case in the broader Chinese market. Active managers can manage this risk by building more diverse portfolios and by investing in stocks not represented in MSCI China. The ten largest stocks in the MSCI China index make up over 40% of the market. For A-shares, it’s less than 20%. The A-shares market is less concentrated than the MSCI Emerging Market and MSCI World indices.

Figure 12 and 13

It is also worth noting that the presence of state-owned enterprises (SOEs) in China is higher than in DM. Active managers have the ability to manage exposure to SOEs.

How have active managers performed in China?

China’s equity markets display all the hallmarks of fertile grounds for active equity investors. The long-term performance of A-shares managers has been very strong, even after allowing for weaker performance in more recent years (Figure 14).

The outperformance of SOEs in recent years has contributed to relatively poor performance, given that many active managers have been underweight in this sector.

The chart on the right in Figure 14 shows how median manager alpha has evolved on a rolling 12-month basis over the longer term. The duration of recent performance weakness contrasts with the longer-term picture.

This also highlights that, until recently, the median China equity manager across the broader opportunity set (Figure 15) has fared relatively well (with some variability, of course). Recent underperformance has dragged on performance statistics over all horizons.

China’s equity markets have been impacted by a combination of headwinds in recent years, not only the COVID-19 pandemic. Given the points outlined above, there is a good reason to believe that the future may be different to the last few years. As we have shown, the market continues to look inefficient, and there has been greater uncertainty, which has the potential to amplify the former point and create opportunities for fundamentally driven strategies.

Figure 14
Figure 15

Appendix

A recap on the China equity opportunity set

China’s total equity market opportunity set comprises companies listed in the offshore markets (Hong Kong SAR and foreign listed Chinese companies – including American Depositary Receipts), and the Mainland markets of Shanghai and Shenzhen. The Mainland-listed A-shares used to be restricted for international investors but access restrictions were gradually eased post 2002; especially after the introduction of the Stock Connect scheme in 2014. This enables investors in either the HK SAR or Mainland markets to trade shares on the other using local brokers and clearing houses.

Table 1 provides a wide snapshot of the eligible China stock universe. In US dollar terms, China’s total stock market capitalisation was 413 trillion (including Mainland and offshore markets) as of 20 September 2024, based on data from CICC Strategy Research. This places it behind only the US in market cap terms globally. 

Table 1

There are differences in composition between the Mainland markets and offshore markets, as Figure 11 shows. The offshore market (proxied by the MSCI China, but which now also includes some Mainland stocks) has more of a bias towards consumer discretionary and communication services sectors, which account for almost 50% of the index. The onshore market (proxied by MSCI China A Onshore index) is more diversified and has greater exposure to sectors such as industrials and IT.

Andrew Rymer, Senior Strategist, Schroders
Andrew Rymer, Senior Strategist, Schroders

The MSCI China All Shares index is shown as representative of the integrated, broad China equity market opportunity across Mainland and offshore markets. Close to 48% of the stocks in this index are Mainland China listed, with 48% listed in Hong Kong SAR and the remaining 4% listed in the USA.

There is also a broad range of companies in market capitalisation terms. Table 2 shows the number of companies in each size segment, from large cap through to mid and small cap in the Mainland and offshore markets.

It should be emphasised that good liquidity across the market cap range is another feature of China’s Mainland stock markets. This is key for active investors to easily trade in and out of stocks without materially impacting pricing.

Table 2

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