Allocations to Chinese equity and fixed income should stand alone rather than be part of global or emerging market strategies for investors looking for diversification and potential excess returns from the vast opportunity set that Chinese financial assets represent.
A standalone allocation would do justice to China’s growing weight in major global market indices and its maturing financial markets. With the country now accounting for nearly 18% of global GDP and 11% of global equity market capitalisation (see exhibit 1), not only a larger share of investor portfolios is warranted, but also a dedicated allocation.
Would an allocation to China add more to volatility than to returns, in other words, would it lower the portfolio’s Sharpe ratio? We do not think so. The Sharpe ratio of the China index has actually been slightly higher than that of the MSCI Emerging Markets index on average (0.45 vs. 0.33) since 1994.
China has been liberalising its financial markets over the last 20 years and foreign portfolio inflows have increased in response. While there are still issues that limit a greater inclusion of domestic A-shares in MSCI indices, we expect these to be addressed over time, meaning there is still huge potential for investors to benefit as the country’s markets evolve.
We believe a strong regulatory landscape and rising international participation enhance the institutionalisation of a market. When Taiwan and South Korea entered international market indices, foreign participation and investment flows rose notably, so being positioned in China ahead of this trend would be wise. Foreign ownership of onshore Chinese equity markets has a lot of ground to make up relative to, for example, India or South Korea.
With Chinese assets historically showing a low correlation with developed markets and other emerging markets, simply increasing one’s exposure to China via a higher allocation to emerging markets is suboptimal. Investors would also miss out on alpha opportunities from the large dispersion in performance between both Chinese sectors and individual stocks.
The opportunity will also come from new companies listing on the market. While the US is the leader in initial public offerings (IPOs), China and Hong Kong were far ahead of any other emerging market country with a 27% share of global proceeds raised in 2020.
Not only does China’s long-term growth potential beat that of almost any other country, the sector makeup of the China index differs from that of other emerging markets. There are more companies in faster-growing new technology sectors and fewer in volatile cyclical and commodity sectors. This all points to diversification benefits from an allocation to China by itself.
While the Chinese equity market has grown to represent the largest share of the MSCI Emerging Markets index, Chinese fixed income still accounts for a small percentage of major bond indices. The percentage is growing, however, making investing in the country’s bonds part of the global opportunity set for investors, not just an emerging markets opportunity.
As index providers increase the share allocated to China in their benchmarks, billions of dollars of inflows are likely to ensue. We expect that there may be as much as USD 200 billion in 2021, not just from institutional, but also from retail investors.
The appeal to foreign investors of the Chinese market is relatively high yields, a stable currency, and low correlations with other local currency emerging market debt. In addition, there is often a negative correlation with the domestic A-share equity market.
The Chinese corporate bond market is large, but relatively under-researched. Few domestic issuers have international ratings, and domestic ratings are not directly comparable to those from international agencies. This is an opportunity for active investors to identify those issues where the market is not pricing the risk associated with a bond correctly.
Investors understandably worry about debt burdens, but Beijing has been addressing this with its deleveraging push and steps to remove the implicit guarantee policy for state-owned enterprises. This should be positive for the market in the medium to long term.
To attract more foreign investors, policymakers are aiming to create a unified regulatory framework. The government is also enabling international rating agencies to rate onshore companies. On the currency side, currency controls could be loosened to allow for greater freedom in the movement of capital. We expect further currency liberalisation over time.
Given the sticky domestic client base, particularly in the higher-quality onshore bond market, trading in size or in the secondary markets can be challenging. Over time, a more diverse investor base including foreign investors with different risk and return objectives should enhance liquidity conditions.
China’s bond market is the second largest in the world, but most emerging market debt investors have at most a negligible allocation in their portfolios. We believe this market offers the potential to obtain above-average, risk-adjusted returns, especially for those who have the skills and experience to analyse it.
FOR A DETAILED ANALYSIS OF THE OPPORTUNITIES, READ A STANDALONE ALLOCATION TO CHINA
Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients. This document does not constitute investment advice.
The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay. Past performance is no guarantee for future returns.
Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher-than-average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity or due to greater sensitivity to changes in market conditions (social, political and economic conditions).
Some emerging markets offer less security than the majority of international developed markets. For this reason, services for portfolio transactions, liquidation and conservation on behalf of funds invested in emerging markets may carry greater risk.
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