By Patrick Ghali
The Chinese markets have clearly experienced a turbulent year. Fears about slowing growth, decreasing imports, and other concerns ultimately lead to significant mainland index losses. New rules introduced by the Chinese government further confused many participants – leading many to believe that the Chinese market was too immature to invest in (although to be fair, many of the policies introduced are reminiscent of those adopted in response to the 2008 crisis). Do these recent developments mean the potential to extract alpha has vanished in China?
Of course not, though investors need to be smarter and not just buy into a mainland index and hope for the best. For foreign institutional investors (FII) there is therefore a need to understand the opportunities and idiosyncratic market dynamics more clearly in order to be successful.
We should not lose sight of the economic realities – China is still growing at around 7% according to official figures, and investors shouldn’t forget that 7% of today’s GDP is in nominal terms much more than the 10% GDP growth in past decades, when the economy was a fraction of what it is today. Additionally, China remains the world’s second largest economy, and largest by purchasing power parity; its USD reserves are larger than the next five largest holders combined; its exports constitute 30% of the world’s total. In such a market place, with such buoyant economic activity, it is imperative to understand the underlying fundamentals of the companies and the indices in which one is investing. More exciting though are the inefficiencies its capital markets exhibit and the resulting alpha opportunities for hedge funds. Investors are also well served by broadening their definition of China to include what we refer to as “Greater China” (Hong Kong, Taiwan and US listed ADRs of Chinese companies). Simply focusing on mainland listed shares is myopic and unnecessarily limiting.
FIIs also need to remember that unlike the developed markets where information is freely available, analyst coverage is ample, and the regulatory framework is by and large known, predictable and stable, this isn’t always the case in China. Companies might be selling internally or regionally, and some of the largest companies are state owned. In many respects, China presents a challenge to FIIs when the accuracy and quality of available information might not be as one expects, and where what is reported differs from Europe and the U.S. Moreover, as analyst coverage is not as prevalent as it is in the UK or U.S., this means it is imperative to conduct proper, proprietary analysis of companies before investing, something which is proving extremely challenging for non-locals.
Additionally there are few who can claim to have special insight about regulatory, economic, or industrial policy in China if they are based abroad, in contrast to Chinese based managers who are better able to establish asset values and gauge potential risks.
We feel that in order to fully take advantage of the opportunities that present themselves in China, FIIs not only need to seek out trusted local partners, but also broaden their horizons and to start viewing China as ‘Greater China’. This will allow them to exploit the differences in liquidity, investor bases, and quality of available information provided by these extremely interconnected yet different markets. It not only creates very attractive arbitrage opportunities, but also means that shorting is now part of the available tool-set. Further still, the current ratio of hedge fund assets to market capitalisation in China is only 0.6% – roughly one tenth of what it is in the US. It is easy to see how less competition means more persistent and sustainable opportunities for alpha creation.
Ultimately understanding the real value presented by Chinese markets isn’t easy, but for those that do the financial rewards – against a backdrop of emerging markets turmoil and anaemic growth in Europe– can be very significant. More than anything else though, China, assuming you pick the right partners, continues to be an excellent alpha market .What it truly boils down to is being able to access the local knowledge. Therefore for FIIs there are clear advantages in allocating to managers in the country itself; those on the ground; reading the market for what it is.
Patrick Ghali is managing partner at Sussex Partners
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