The CIO Agenda: Investing in China

Recent regulatory changes have opened the door even wider for foreign investors to access onshore Chinese markets. Access to China’s domestic capital markets continues to be relaxed while investors with a QFII license are well positioned to benefit from greater access, lower trading costs and further potential expansion of the permissible instruments.

Does trading in Chinese financial and commodity markets provide attractive return and diversification characteristics for a systematic manager? And why are Chinese equities still such a minor element of most portfolios?

Giuliana Bordigoni, Director of Specialist Strategies at Man AHL and Ori Ben-Akiva, Director of Portfolio Management at Man Numeric, join Sandy Rattray on The CIO Agenda to discuss the diversification opportunities for investors in Chinese markets.

Recording date: 26 May 2021

Episode Transcript

Note: This transcription was generated using a combination of speech recognition software and human transcribers and may contain errors. As a part of this process, this transcript has also been edited for clarity.

Sandy Rattray (00:05):

I'm Sandy Rattray, CIO at Man Group[. Welcome to The CIO Agenda podcast. Today I'm joined by Giuliana Bordigoni, Director of Specialist Strategies at Man AHL and Ori Ben-Akiva, Director of Portfolio Management at Man Numeric. We're going to be talking about China. So just to kick off Ori, what is it that makes China an interesting place to invest?

Ori Ben-Akiva (00:28):

So there are a number of attributes that, that make the China markets a very interesting and attractive one for an investor such as Man Numeric, and the key ones are inefficiency. The diversity and diversification of the investment opportunities offered the level of liquidity and ultimately the amount of data and all of these coupled together creates a market environment that offers interesting potential for quantitative approaches.

Sandy Rattray (00:59):

And Giuliana, from your perspective as a macro investor, what does the market look like in China? What, what, what can you invest in as a macro investor?

Giuliana Bordigoni (01:09):

For me the most interesting aspect is the diversification. So it's exactly what market you can access that are unique to China. So you can, you can obviously invest in equities. You can invest in bonds, so fixed income in general, and you can access commodity markets. And if you stop for a second on the commodity markets, you have markets which are truly unique, like eggs, apples, that you don't find elsewhere. And you find other markets like industrials, which are not very liquid outside, well they either don't exist or they are not very liquid outside China, like steel or float glass.

Sandy Rattray (01:58):

So you have these different commodity markets. How liquid are they? You know, you might imagine that for example, eggs would be a market that had very little liquidity.

Giuliana Bordigoni (02:11):

Yeah. So that is the other appealing part of China. So the markets, the commodities in general are among the biggest in the world. So if you look at the number of contracts traded commodity worldwide, you have eight. The top five are Chinese commodities.

Sandy Rattray (02:48):

Okay. So let's move a little bit and just talk about the structure of the market. So already, maybe just to kick it off, can you give us the beginner's guide to the structure onshore and offshore equities in China and you know, how, how do investors access these, what are the differences between the onshore and the offshore markets?

Ori Ben-Akiva (03:12):

There are a number of differences in a number of mechanisms for accessing on shore, or what's known as the embassy or the China, a investment universe from the equity perspective. The first available access point for foreign investors was back in 2002 with the introduction of the QFII program. But the QFII program in its early inception had some cumbersome cumbersome hurdles for implementing. And so there wasn't much adoption at that point in time, but the biggest adoption for foreign access was with the advent of the stock connect in 2014, and this stock connect is a mechanism by which investors offshore can invest onshore into China through a connect program with the Hong Kong exchange. The biggest significant change to the connect has been the addition of the Shenzhen exchange to the connect program in 2016, this really opened up the investment universe much more broadly to onshore equities and also along with that has been an expansion in the ability in the QFII program recently to allow a much more flexible access into the marketplace for investors.

Sandy Rattray (04:31):

And if you look at the Chinese equity markets today, onshore and offshore, then we still put them into emerging markets as the classification, how large is China as a portion of emerging market equities,

Ori Ben-Akiva (04:47):

As far as the MSCI China index today, China represents 37% about approximately 37% of the total index exposure. And keep in mind that that is, that is the case with only a 20% inclusion factor for the China A securities. So if you were to assume a more normalised inclusion factor for on-shore securities, then the expectation is that China, China will represent close to half of the emerging market index. At which point in time, you know, it will be more similar in composition to the representation of the US in the global developed index.

Sandy Rattray (05:26):

And so maybe we can just dwell on that a little bit. So some are depending on how you calculate it a third or so of emerging market equities with the current inclusion factor and potentially much more at a normal inclusion factor, are you finding that investors want to allocate that larger portion of their portfolios to China? And if not, then what are they doing about it?

Ori Ben-Akiva (05:48):

Yeah, so there's a number of different approaches that we've seen allocators take the primary one so far has been to allocate to China A through their global emerging market mandates which means that ultimately they're getting a very underrepresented exposure to China A securities in comparison to their capitalisation. And to point out China A securities currently represent the second largest market globally and most liquid market on a cap relative basis in comparison to say the US. Now the other approach would be to make direct allocations to onshore China A equities strategies or managers, but that comes with some elevated risk as well. One of the key risks is that the China A share market exhibits elevated volatility, there's been a history of boom and bust cycles as well as there's some limitations on market mechanisms, such as shorting and financial derivatives that also provide some other stumbling blocks in terms of hedging, some of the beta risk that you would be taking.

Sandy Rattray (06:58):

And so are you finding that different investors in different parts of the world are taking different approaches? They've obviously got different considerations and and concerns of their own. So are there some parts of the world where you're seeing more China investment and other parts of the world where you're seeing less China investment?

Ori Ben-Akiva (07:19):

I wouldn't say it's necessarily regional, I'd say it's more a function of the allocator's experience in emerging markets and tolerance for taking on tracking your risk or their, you know, how they perceive the inefficiency opportunity on shore and in China A versus other markets. But one of the things that is definitely a common theme is that more and more investors are starting to view China, not just China A, but just the broader China equity marketplace environment as a, as an asset class in a sort of a separate asset class decision point, much like many investors considered the US. And that is, you know, due to the nature of its size, its weights within the index and the breadth of opportunities that, that marketplace affords investors.

Sandy Rattray (08:10):

Okay, great. Well, we'll come and talk about alpha in these markets in a moment. But before that I'd like to talk a little bit more about the macro markets with Giuliana. These markets weren't available to foreign investors until really quite recently. So what's happening?

Giuliana Bordigoni (08:26):

What's happened is that September last year there was, there was an announcement on an expansion of the QFII scope. Now what is QFII? It is the program that grants offshore investor access to at least some of onshore Chinese markets and up to November last year, these included the cash equities, cash bond and index futures for hedging purpose only. In November they announced that from November onwards, they would like offshore investors with a QFII license would be allowed to invest in a list of commodity futures, futures more in general. as of today, there are not yet any futures available for QFII. There have been about 20 markets that have been sent for approval to CSRC from the exchanges, but they have not been approved yet, but this is the big change that in the next month. So, or the timeline is not defined. Option investors will be able to invest in the futures market or at least in some of them.

Sandy Rattray (10:01):

Digging into that just a little bit more because at one level you could imagine you have a set of markets previously not accessible to foreign investors that are very liquid, very diversifying versus most of the markets that they already have access to as we've talked about. So they might actually want to allocate a lot to China. Will they be able to allocate a lot or are they going to start in small size?

Giuliana Bordigoni (10:23):

At the moment? Our experience on shore is that there are on the commodity side there are exchange limits. So they limit option investor face are these exchange limits data imposed by the exchanges and that is going to limit the size that we will be able to do.

Sandy Rattray (10:48):

Okay. So it's going to take a while before it becomes a significant part of those portfolios. Yes. So let's move back now to equities and Ori just to talk about both the alpha opportunities, but also the diversification that Chinese equities present. So why don't we start with the diversification? So how should we think about how correlated or uncorrelated Chinese equities are with other equity markets around the world?

Ori Ben-Akiva (11:18):

Sure. So there are, there are two perspectives I would take on the diversification opportunity with investing onshore into China A. The first is just the correlation with other equity markets which is lower than the opportunity that is offered by say the global emerging market index relative to the MSCI world index, which is the developed market index. So China A is in many ways the most diversifying liquid equity market available to investors today. The other is just the alpha diversification opportunity that China A exhibits, the, the factor correlation. If you think of the core factors through the barra lens the more traditional bar lens, the correlation of the factor returns with other markets. And this is comparing China A to other major markets is close to zero. So there is significant factor diversification, payoff benefits as well to investing in the China A share market. And it really highlighted by some how the factor returns played out in March of 2020 during the peak of the pandemic and, and market share and government shutdowns that the value factor underperformed dramatically in all developed markets at that point in time, it was actually quite positive in China. So quite a bit of diversification opportunities.

Sandy Rattray (12:44):

So that's a great example of how different the markets are. If we could talk a little bit about the signals you use as a quant equity investor, how different to the signals or the factors that you're using in China to those that you use in other markets around the world?

Ori Ben-Akiva (13:03):

There's definitely some commonality in the philosophy that we employ outside of China and, and on shore, I'd say that the, the key advantage that the China A share market affords us from a quantitative perspective is the breadth of available alternative data sets. There's well over 80 alternative data sets that we've identified for research in the China A share market of which we are already currently using a, a fair amount that we have found to be, to be very productive and, and those tend to be focused in the areas you know, web scraping natural language processing, e-commerce based information, social media sentiment based information, even ESG based information. And so it's a very rich market from an alternative data perspective. And at the same time, it's a market that's in a very interesting evolution in terms of factor payoffs and, you know, and, and the reason that's the case is that you have a long history. The market's been around for 30 years or so, and much of that history was very driven by onshore investors with very limited institutional or foreign access. And as that market evolves, we expect to see more institutionalisation of the marketplace. We expect to see a significant growth in asset management industry offerings and we expect that the drivers of the marketplace to transition as well. So it is a market in flux as well, which creates interesting opportunities.

Sandy Rattray (14:34):

Was it a surprise to you that actually more similar than different perhaps factors seem to work well in China?

Ori Ben-Akiva (14:43):

I think that we were pleasantly surprised that some of the fundamentally oriented models that we've had, you know, the long histories of utilising within developed markets also exhibited, you know, attractive payoff patterns within the Chinese share market, given, you know, the higher volatility and higher turnover nature of that marketplace. We're also cognizant that there are some behavioral bias based opportunities in China A that are quite significant, but that might become less so significant going forward as, as that market evolves. You know, one example would be the post earnings announcement trip. This is a very well-known well, academically, academically researched you know, anomaly in the market where after a company announces earnings, there tends to be this, this earnings announcement drip after the fact either positive or negative based on, on the outcome of the earnings announcement. And that's something that over time in developed markets has become far less, you know, far less attractive from a payoff perspective because investors, you know, discount that information very quickly into the price of the company, yet at least onshore currently that announcement drift is still continues to offer really attractive properties.

Sandy Rattray (15:54):

Okay, great. Well, and let's come back later on and talk a little bit about the risk of the, at a market level of Chinese equities, and also whether equities are participating in the growth of the economy, which has obviously been spectacular in recent decades. But before doing that, I'd like to spend a bit of time back on the macro markets with Giuliana. So you've run strategies onshore for a number of years. How has that experience made you think about running strategies for offshore investors?

Giuliana Bordigoni (16:32):

Again, for many years I've been working in trying to new drivers to our existing portfolios. And what we have seen in China is that you should take like a simple strategy. Like, so we're, I'm talking now about a momentum model with a holding period of a couple of months, and then you run the most liquid Chinese commodities and you compare it with the a similar, like the same model, but ran on some global commodities. And then what you see, you see that the two are not highly correlated related. So actually adding this like a momentum or trend following system on Chinese commodity helps diversify your trend following in global markets more in general, but also in global commodities.

Sandy Rattray (17:42):

So in many ways, then a similar observation to Ori that existing models we've used in other parts of the volatility turn down function very well in the Chinese markets. Can you give it a little bit more color on the nature of the market? So who are the other investors in the macro markets today? Does that look like other parts of the world? Is it hedgers and speculators and all the people that we read about in US or other Western markets, or is it a different makeup?

Giuliana Bordigoni (18:19):

What is the current market view is that there is a higher retail participation in Chinese market. So the view is that the retail participation is around 80% on average, with lower participation in agriculture market and higher participation, retail participation in financial futures. So we do see a slightly different split between institutional and retail investors.

Sandy Rattray (19:02):

Okay. So let's get back now to risk and market returns Ori the Chinese equity markets have shown quite a lot of volatility over the years, and some might argue they haven't really kept up with the performance of the Chinese economy. So can you give us a bit of colour as to both the risk of the Chinese equity markets and whether it will participate to the same degree in economic growth that perhaps we've seen in other parts of the world?

Ori Ben-Akiva (19:33):

So we'll start by focusing on the risk. And I think one of the key risks to equity investors in the China onshore market is some of the limitations on market mechanisms that would otherwise, you know, dampen volatility in certain market environments. So the lack of shorting which is quite limited at this point in time and financial derivatives does create some limitations on the ability of investors, long investors to do some hedging. And that's probably, and that is consistent with the elevated level of volatility and some of the boom bust cycles that we've, we've seen historically also as a, as a relatively closed economy until recently, the market tends to be much more sensitive to the directions and the regulatory changes that occur in that marketplace in comparison to some other markets now, ultimately than the day, this also creates opportunity.

Ori Ben-Akiva (20:34):

It means that the return dispersion in the onshore market which is in the mid 30% range on an annualised basis is significantly higher, almost 50% higher than in developed markets. And ultimately return dispersion is the measure of the opportunity set available to, to stock selection base strategies, like the one that Man Numeric employs. From a participation in GDP growth and economic growth. I think the one thing I would highlight, because that is a bit out of our kind of area of expertise, is that, you know, the China A market offers significant exposure to, to newer technology companies to kind of more disruptive technologies, as well as companies that are supplying to the consumer demand oriented growth in the marketplace. And that's something that's less accessible outside of the market outside of the China A market off shore. And so that offers an attractive opportunity to kind of gain exposure to the growth of the middle class on shore.

Sandy Rattray (21:46):

Great. And let's now turn back to commodities and talk about the sensitivity of a number of the markets that you're active in also to growth and maybe to inflation as well. In a previous episode of this podcast, we've talked about how momentum in commodities might be a good head to global inflation. So does the same thing applies in China? So firstly, are we seeing the same types of effect from the commodity markets that we see in Western markets, a very big supply demand imbalances, and secondly, is that likely to provide a hedge to inflation Giuliana?

Giuliana Bordigoni (22:28):

Yeah, absolutely. We are seeing definitely very strong trends in commodity the recovery theme has played in China even earlier than outside China, I would say. In fact we have seen China recovering from the pandemic sooner than the other economies. And if you look at it last year, China at the GDP grow 3.2% compared to other economy that they've seen negative number. And this year already, we have seen a Q1 number of like 18, over 18%. So definitely the theme of recovery and higher commodity prices as been playing in China. In general, if you look at which market we see in China, we see markets strongly connected to commodity production and consumption because these are the markets China needs. I mean, we have the one key to data economy and what we've seen in the year but more in general in the last decade or so is being the growth of China coming through these future markets that we trade.

Sandy Rattray (23:58):

Okay. Let's now just look into the future and see how it might evolve. So for you, Ori, you're managing Chinese equity portfolios of foreign investors, or non-Chinese investors, the weight or the allocations that those investors have today to China is still pretty low. So what do you, what do you wish for, what do you hope for, in terms of the future? What do you hope would change for those non-Chinese investors to, to increase their allocations? What, what are we waiting for?

Ori Ben-Akiva (24:33):

I think that ultimately a lot of investors are anchored to the weightings that are provided by the index providers such as MSCI. So there is some wait and see that's going on with how the index provider views accessibility for foreign investors and adjust their weights accordingly. I do think that there are some investors that recognise that you know, of all the markets globally, the one market that can expect a tailwind of flows in the coming years is the onshore China market. It's likely that over time that MSCI will raise the inclusion factor which will ultimately lead to flows, passive and active into the marketplace. So I think it's a, it's an attractive opportunity from a tailwind perspective which is in contrast to other markets where that's not to be, you know, not to be structurally expected. And then ultimately the other one is just that as the, as China becomes a more prominent part of the index, you know, we do expect to see more investors to think of that allocation as a separate decision point, as opposed to part of the broader global emerging markets allocation. And that should create more opportunity for, for managers who offer attractive idiosyncratic China offerings.

Sandy Rattray (25:51):

And do you have investors that are doing that today that are saying that China is sufficiently different to other markets in the emerging market indices that should just be treated differently either at a higher or lower weight to what the index suggests?

Ori Ben-Akiva (26:08):

Yeah, so we're definitely seeing investors that are dipping their toe in that direction, as well as investors that are starting to think of a framework where China is viewed separately from, you know, the broader emerging markets, mandates. The one limitation, which, which, which I mentioned is that because of the lack of financial derivatives, ultimately the exposure, any active exposure you take to China A in comparison to other markets is a risk that is nearly impossible to efficiently hedge at this point in time. And I think that's ultimately a pretty big limiting factor. And so one of the things that might alleviate that quite significantly is introduction of some financial derivatives, such as the one that was discussed in Hong Kong for the MSCI China A index that will give investors much more flexibility to express their views on China A vs China H more effectively,

Sandy Rattray (27:03):

And Giuliana, from your perspective, what does the future look like for running macro strategies in China? What are you hoping for that makes this market grow?

Giuliana Bordigoni (27:17):

Expansion of the QFII program last September as being a great step into the future. And I hope the first few markets will be approved by CSRC to be tradable via QFII this year and going forward in the next few years, we will be able to trade via QFII the onshore futures.

Sandy Rattray (27:53):

Wonderful. Well, thank you. Giuliana and Ori in summary, I think you both said that the models and the approaches which we've used in other parts of the world are translated really very well to investing either in Chinese equity or in the macro markets in China. You both said that the amount of investment by non-Chinese investors in China today is really quite low, and that this represents one of the enormous opportunities for growth in the future. And that we think that that's an area where we're going to see much more in the coming years from our investors. So thank you again very much Giuliana and Ori for joining us. And to our listeners. Thank you very much for listening. You can follow The CIO Agenda on apple podcasts, Spotify, and other podcast platforms to receive each new episode. Thank you. And goodbye.