China continues to offer tremendous long-term growth potential and numerous compelling investment opportunities, in my view, particularly in today’s volatile and dispersion-filled market. In our recent white paper, we outlined the rationale for increasing exposure to China. I believe investors should think about their China exposure holistically. Here, I dive deeper into the case for allocations across different asset classes in the region.
Understanding the opportunity set
For long-horizon investors in China, we believe allocations that target domestic return drivers are particularly attractive. We think these exposures can be accomplished in parallel across both public and private equities by the inclusion of dedicated China or Asia strategies focused on the domestic consumer. Importantly, over both the intermediate and long term, we see good return potential in China’s equity markets, and we believe exposure to the region may play an important role in achieving investors’ investment objectives.
In addition, we believe China- or Asia-focused hedge funds may play a complementary return-generation role alongside public and private equities. Our research shows that such strategies benefit in markets with high levels of dispersion and low levels of intra-stock correlation. Notably, however, like private strategies, hedge funds have a high level of idiosyncratic risk, and manager selection is therefore paramount to success.
In contrast, we are less constructive on incorporating dedicated China fixed income strategies at this juncture. For growth-oriented investors, we instead emphasize global opportunistic managers that rotate in and out of the space as a tactical lever.
The case for public equities
Our intermediate-term, annualized return assumption for the MSCI China Index is 14.8%. We believe this is attractive relative to both China’s forecast history and our current developed market equity forecast (+8.6%).1
While evaluating allocations to Chinese equities, it is important to remember the country is underrepresented in market-capitalization benchmarks relative to its share of global GDP, its sheer size, and the breadth of its listed companies (Figure 1). We believe China’s representation will increase over time and think investors that prudently increase allocations to China will shift exposures toward what the major indices may look like in the future.
We therefore remain constructive on strategic overweights to Chinese equities with two important implementation nuances: (1) focusing on the domestic economy with a quality bias and (2) being cautious of national security and trade-related concerns. Our rationale for this overweight is three-pronged: diversification, risk-adjusted return benefits, and increased alpha potential as outlined in the above-linked paper.
Importantly, as part of a more targeted approach to constructing emerging markets (EM)/China allocations, we specifically focus on domestic exposures with an emphasis on new-economy sectors and regional champions. We also believe global EM or regional pods are a strong complement to all-China or dedicated A-shares exposure given their linkage to onshore macro policy support and their overall resilience.
While the geopolitical backdrop is certainly significant and may cause bouts of volatility, we expect it to have a relatively limited long-term impact given Chinese companies’ comparatively small US market share (2.4% for the MSCI China Index).2
Private equity and hedge funds: Benefits and best practices
Chinese private equity offers investors several attractive features. The space is generally concentrated in the compelling new-economy sectors referenced above — tech, consumer, and health care. It also provides regional diversification to global private equity, which tends to be US-centric. In recent years, trailing returns for Chinese privates have been strong, benefitting the space’s early movers.
China’s venture capital (VC) ecosystem is also expanding rapidly (now ranked second behind the US). In2018, VC investment in China hit an all-time high (US$24.9 billion), suggesting potential froth in the market. VC investment subsequently moderated in 2019 (to US$15.0 billion), bringing it back in alignment with pre-2018 levels. 3
Going forward, we anticipate some compression to illiquidity premiums as more capital moves into private investments in China. That said, illiquidity premiums tend to widen in recessions and crisis vintages have historically been relative outperformers. We believe investors with sufficient liquidity may benefit from maintaining their private pacing strategy and selectively adding to cycle-tested managers where Chinese investments are part of the opportunity set.
As with global private equity, we believe there are a few best practices for allocating to China-focused private equity funds:
- accessing top-quartile managers through a strong manager selection process given the significantly wider range of potential outcomes compared to public markets
- investing with a General Partner with proven strong governance and controls
- planning liquidity waterfalls
- maintaining vintage diversification
Hedge funds may also play a key role dependent upon manager skill and access. We believe Chinese equity markets — with their high levels of dispersion and low levels of intra-stock correlation — are ripe for long/short investing. However, implementation challenges related to liquidity and regulatory issues should be carefully explored during due diligence.
Fixed income warrants a global, tactical approach
Given low yields and return expectations for Chinese fixed income markets, I do not yet believe this warrants a dedicated strategic exposure for long-horizon investors. We see more attractive opportunities in equities.
Global opportunistic managers may, however, look to access Chinese government and credit issues as a tactical asset allocation lever/diversifier. Due to the more volatile fluctuations in the renminbi, currency-hedging strategies could also be beneficial for these investments.
Importantly, we will continue to evaluate this market as the inclusion of renminbi bonds in global bond benchmarks grows, international rating agencies deepen their coverage, and credit liquidity improves.
We believe dedicated allocations to public and private China/Asia-focused equities — with an emphasis on domestic drivers — offer intriguing opportunities for long-horizon investors. In addition, we think such exposures could be complemented by global fixed income managers who are able to rotate across locally denominated sovereigns and credit. Chinese markets also provide significant opportunity for long/short investing — though these investments are dependent on various implementation considerations.
In our view, increasing allocations to China across multiple asset classes is warranted by the country’s rising global economic stature and enduring growth potential. We think this justification will continue to increase over time and investors should continue to think holistically about their aggregate portfolio exposure to the region.
1Capital Market Assumptions as of 30 June 2020. Assumed market returns are based on the Investment Strategy Group’s expectations for future dividend yield, earnings growth, and valuation change. Assumed volatility and correlations are based on historical analysis of the representative indices. The indices used are MSCI World (developed market equity) and MSCI China (China equity). The analysis herein relies upon assumptions and other expectations of future outcomes and is, therefore, subject to numerous limitations and biases. Future occurrences and results, which may also be formulated based on subjective inputs (i.e., strategist/analyst judgment), will differ, perhaps significantly, from those reflected in the assumptions. Returns and other assumptions shown are hypothetical and are not representative of an actual account. This material is for illustrative purposes only and is not representative of future returns that an actual portfolio may achieve. This material is not to be relied upon as, nor considered, investment advice or a recommendation to change any portfolio or allocation. Assumptions are based on historical performance and expectations of the future. PAST PERFORMANCE IS NO GUARANTEE OF FUTURE RESULTS. ACTUAL RESULTS MAY DIFFER MEANINGFULLY FROM ASSUMPTIONS. This illustration does not consider transaction costs, management fees, other expenses, liquidity, or the impact associated with actual trading. These elements associated with actual investing, among others, would serve to impact the assumed returns herein, and results would likely be lower. Any third-party data utilized in the analysis is believed to be reliable, but no assurance is being provided as to its accuracy or completeness. | 2Source: MSCI China Index. Allocation as of 30 June 2020. | 3Source: Emerging Market Private Equity Association (EMPEA).
Please refer to the investment risks page for information about each of the following risks:
- Alternatives risks
- Capital risk
- Credit risk
- Currency risk
- Foreign and emerging markets risk
- Liquidity risk
- Fixed income securities market risks
- Manager risk