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China has fast become a market impossible for investors to ignore, being now the second largest after the US. But for many, investing on the Chinese mainland is still a new experience, and the market’s size and relative immaturity can make it difficult to navigate. So how are UK funds approaching it, and what are the crucial things to keep in mind?
Pension funds tend to already have exposure to China if they are invested in passive funds; China has begun to embrace foreign ownership of its companies since 2014, and the MSCI Emerging Markets Index started to partially include China large-cap A-shares in May 2018. In 2019, MSCI increased the inclusion ratio of China A-shares in its Emerging Markets Index to 20%.
How are pension funds approaching the topic?
The rapid growth of the market has led many to believe that not having exposure is now a bigger risk than having it. A recent mallowstreet survey found that more than half of schemes 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.
Several investment consultants have also begun to ask whether it is appropriate for pension funds to have as much as 55% of their equity weighting in the US and only 4% in China, notes David Kidd, a director at trustee firm LawDeb Pension Trustees. This shift in advice could in time show in pension funds’ allocations.
Kidd says that often, investors like pension funds achieve greater exposure to China by using an active global equity fund or a diversified growth fund.
“One of my clients, however, has gone further. It wants to achieve the diversification and growth benefits of specialist exposure to China. It has appointed a discretionary manager to invest in liquid assets including China A-shares,” he says. But to have a dedicated China mandate, “the trustees need to have a reasonably high governance budget. They also need to recognise the geopolitical concerns and ESG challenges”, he observes.
This approach might still be the exception, however. Mark Hedges, a professional trustee at Capital Cranfield, says most of the investments he has seen have been in pan-Asia funds rather than China-specific, due to “a combination of diversification, risk management and limited resources for due diligence”, reflecting the size and capacity of the pension fund.
“Larger funds with deeper resource pockets are likely to look more specifically at China,” he notes.
China, alongside other developing Asian economies, is likely to be one of the key drivers of wealth creation over this decade, he says. Hedges acknowledges that China’s GDP per capita is still very low compared with more developed economies, but adds: “It is growing, and this will increase disposable income for a very large number of people.”
From an investment perspective, China and Asia are likely to present opportunities given this background, he argues, but points out that in a globalised market, businesses in Europe and the US that trade with or have operations in China can benefit from this scenario as well.
Pension funds' China exposure is expected to grow
While UK pension funds are thus still considering how they can access the market, for China specialists, the path is clear; given its size, China should “definitely” be in its own bucket versus a pan-Asia allocation, says Ken Wong, client portfolio manager at asset management firm Eastspring Investments. “When China becomes significant... when people take it seriously as a counterpart to the US, you would see a lot of exposure,” he predicts.
However, global investors are currently underweight China because of the uncertainty created by government crackdowns on the private sector.
“They don’t know what’s noise and what’s facts because the transparency level is not very high,” he says, as the Chinese government does not give regular updates about its plans, but for those who pay attention, events such as the recent forced closures of education and tutoring providers did not come out of the blue, he argues.
“What's happening did not happen overnight, there was a lot of talk... if you were following it, you could have seen it. The Chinese government is not like the Fed where they tell the market at every corner what’s going to happen, but they give hints... in working papers,” he says.
China's approach to ESG
The latest market intervention is China’s way of implementing the S of ESG, he says, to avoid inequality spiralling out of control and create a broader consumer base – as well as to support the birth rate of a country that is headed for a demographic cliff edge due to its decades long one-child policy. Now that this rule has been eased, people are still often choosing not to have many children because of the high cost of education.
When it comes to ESG, while the S part is being addressed by the government at the moment, Wong says he is not worried about the E part as China is investing heavily to reduce emissions by 2060.
Governance is left as an area marked for improvement, which is what managers must look for in investee firms by keeping a log about firms, and regulators are now also requiring companies to disclose whether they have ever been fined for anything, according to Wong. Understanding the Chinese government’s policy goals generally is key to identifying the sectors that are at risk of state intervention, he explains.
As well as keeping a close eye on policymakers’ working papers, investors and managers seeking opportunities should know how the market is changing. The figure invested via stock connect programmes in the first half of 2021 already exceeds the whole of 2020, with foreign ownership of Chinese companies steadily increasing, Wong points out.
“We are seeing a lot more foreign ownership in A-shares, that piece of the pie will always continue to grow, particularly if the MSCI continues to increase the weightings,” he says. This influx of foreign institutional money also means that while the market previously consisted of 85% retail investors, that proportion is gradually declining.
“Five to 10 years ago, it was much easier to generate alpha because there were many more structural inefficiencies. Today these are not there anymore,” he notes, adding that to generate alpha, increasing the need for managers to be in tune with government policy, their surroundings and liquidity conditions in order to form a view on markets.
Why the right manager is crucial
For those investors opting for a dedicated active allocation to China, manager selection is crucial, agrees Shuntao Li, who co-heads the manager research team at consultancy Barnett Waddingham. She 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 says, though other aspects, like the investment philosophy, processes and ability of the team are also important.
The language and culture barriers are high, she warns, 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 are your considerations when looking at a potential China investment?