Is China just too big to ignore?

Pardon the Interruption

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The sheer size of the Chinese economy means ever more UK pension schemes want to gain exposure to this part of the world – increasingly considering the risk of not being invested greater than that of being invested. What are the key things to keep in mind? 
 
Investing in China is one of those topics that will bring out emotions among trustees and professionals, but however one feels about investing in a country that suppresses free speech, trustees may soon be forced to learn about this market. 
 
Most are already keen to know more; a recent mallowstreet survey found that more than half of schemes surveyed were already investing in mainland China or planning to do so later this year. Just over a quarter were considering investing in China sometime over the next one to three years, where equities have delivered stellar returns this year. 
 
Source: mallowstreet Insights
 
 
China’s A-shares, listed onshore equities, became accessible to Western investors in 2014 via stock connect programmes, giving access to what is now the world’s second largest economy, which is still growing amid a global pandemic and has transitioned from a cheap industrial centre to a huge tech focused economy. 
 
Source: RisCura
 
 
“Major stock and bond market indices have started to include China more. This has created major asset flows into China,” said Shuntao Li, who co-heads the manager research team at consultancy Barnett Waddingham.  
 
The MSCI Emerging Markets Index started to partially include China large-cap A-shares in May 2018 to make up 5% of the index only; in 2019 MSCI increased the inclusion ratio of China A-shares to 20% in its Emerging Markets Index. 
 
Source: RisCura
 
 
This greater inclusion in indices means that “even if you don’t make an allocation explicitly it’s important to be aware of China a bit”, she said. And it is not just index trackers increasing their China inclusion that will force investors to learn about China, but also the fact that many global companies will have the majority of their revenue coming from China. “The world is so interlinked, you can’t not have something,” Li observed. 
 
The interlinking also applies on a political level; former US president Donald Trump blacklisted several companies with alleged links to China’s military. President Joe Biden has delayed the implementation of the ban until 11 June and given US persons until November to wind down their existing holdings, but most major index providers have already removed the affected companies, many of which fall into the telecoms sector. “We don’t know what’s going to come,” said Li. 
 

RMB is a ‘hard currency’ 

 
Even though China is included in emerging market indices, it may not be useful to apply this view any longer, particularly when it comes to bonds. “A lot of people still have this mind frame that China is emerging market debt. But what’s changed this is the currency... I would say in terms of how widely it’s used in trade settlements and in terms of volatility, it’s a hard currency,” argued Li. 
 
The credit rating of the Chinese government is “pretty good” compared with other major emerging countries, she said, adding that the lack of China bond allocations could be down to familiarity.  
 
Source: mallowstreet Insights
 
 
Yields are higher than those that can be had from developed market bonds but lower than typical emerging market debt, but Li added that she has not seen clients look at China bonds. Mallowstreet's survey shows that most schemes expect returns from Chinese bonds to outperform developed markets. 
 

Why managers are important 

 
Aside from having gradually opened capital markets up to foreign investors since 2002, the Chinese government now permits the creation of wholly owned Chinese subsidiaries by non-Chinese companies, whereas previously these had to be set up as joint ventures. This means global asset managers have been setting up teams in the country. 
 
For an active allocation, manager selection is seen as key in a market consisting of thousands of stocks and made inefficient by the presence of many retail investors. As well as having to have a team on the ground in China, Li recommends picking a manager with a long track record – ideally going back to the early 2000s when the market started.  
 
“Because of the rise of China, I am seeing a lot of more asset managers setting up teams, but they don’t necessarily have a long track record,” she said, though other aspects, like the investment philosophy, processes and ability of the team are also important. 
 
The language and culture barriers are high, she warned, and so “what is essential is the portfolio manager and team have to be Chinese speaking and based in China or Hong Kong,” to ensure they are close to the market and easily able to carry out due diligence on firms. 
 

What about ESG? 

 
“What we’ve seen this year is a lot of people are understanding they are going to do something in China, they get the size, they’ve seen the returns Chinese equities have delivered. A number of funds have been doing searches,” said Faisal Rafi, head of research at specialist consultancy RisCura. 
 
However, at the same time as interest has grown, environmental, social and governance issues have become even more important, and trustees are now rightly asking questions about this, he noted.  
 
ESG can help investors with their fund manager selection, helping to assess to what detail the manager knows a sector or company. 
 
Rafi splits managers into Chinese firms and China specialists. "The key takeaway is yes, global managers are ahead in the formal ESG processes, but the problem is they’re just not as close to companies or don’t have the same gravitas with companies in China. Local managers have much more sway to make changes on ESG,” he said, potentially having access to local governors as well as company CEOs. 
 
While they are still behind, local manager are catching up fast, he believes, and are on board with ESG as they see it benefitting their investment returns. 
 
Find out more about China and ESG in the second part of our China focus next week

What are your experiences and questions around China investment?


Shuntao Li
Lars Hagenbuch
Ally Georgieva
Ryan Daley