With fund managers in the sector lumbered with an extremely difficult market from which to choose stocks, Amandine Thierree, fund analyst at FE, assesses the standout options...
The IMA China/Greater China sector celebrated its third anniversary on 1 January 2014. Rebased in sterling, it has so far lost almost 8% (from 1 January 2011 to 31 January 2014) – as much as the MSCI China index – but is doing better than the broader IMA Global Emerging Markets sector, which lost 17% during the same period.
In the early 2000s, China and its double-digit economic growth sounded like a dream. It plunged in 2008 and bounced back strongly thereafter. But further difficulties in western economies brought home the realisation of how dependent the country was on its exports and, consequently, the need for structural reforms.
President Xi Jinping’s reforms focus on urbanisation, improving household income and a more efficient banking system. He wants the Chinese economy to become more domestic consumption-driven. Such a dramatic change would be painful for any economy.
Can China regain its historic charm?
So, does that mean China is losing its charm compared to the West? Not necessarily. When the short-term difficulty of reforming the world’s second largest economy has passed, investment opportunities will arise in sectors such as services.
A rising middle class will also benefit consumer discretionary stocks. Even with a slowdown, the Chinese economy is still expected to grow at around 7%, which should appeal to investors. How long this level of growth can be sustained, however, is another matter.
The IMA China/Greater China sector, which requires 80% of a fund’s assets to be directly or indirectly invested in China, Hong Kong or Taiwan equities, was created to allow China-focused investors to spot opportunities and provide them with a clear and suitable comparative frame.
It has grown from 26 funds back in 2011 to 38 today. There is no typical fund size: the funds range from as small as $500,000 for the Guinness China & Hong Kong fund to $3.5bn for Fidelity China Focus.
Relative to the MSCI Golden Dragons index, an index composed of non-domestic shares listed in China, Hong Kong and Taiwan, the average China fund does not greatly deviate from the index’s industry allocation. The Chinese equity markets are dominated by two sectors - financials and technology - which together account for half of China, Hong Kong and Taiwan’s market capitalisation.
Financial companies make up the largest part of the index (one third) and of the IMA sector. However, funds in the sector are, on average, underweight both financials and technology.
Concerning financials, this is more than understandable given the lack of transparency, the state’s considerable involvement in the industry and the links to shadow banking, a rapidly growing, yet ominous, part of the economy. The IMA China/Greater China sector has a larger allocation to basic materials than the MSCI Golden Dragons index, according to FE Analytics.
China fund portfolios typically include circa 60 names. The top ten holdings represent 40% of the funds’ assets on average, which is fairly concentrated. Most funds are highly exposed to state-owned or state-controlled enterprises, which is unsurprising given that 78% of the MSCI China index is made of state-owned enterprises.
These are the companies that will be most affected by the reforms, as the state aims to reduce its interference in the economy. Reforms will lead to less price control and more market-based costs: funding costs for banks and energy prices will have to increase. The good news is that the IMA China/Greater China sector is underweight utilities.
Despite experiencing more positive than negative periods since its launch, the statistics for the IMA China/Greater China sector show just how risky Chinese equities are and how difficult it has been for China fund managers.
Only First State’s Martin Lau is rated an FE Alpha manager, which awards outperformance and consistency of a fund manager’s track record over their entire career. The sector average has a negative alpha of -1.46. Volatility is 60% higher than the IMA UK Smaller Companies sector and 10% higher than the IMA Global Emerging Markets sector.
Volatility is further intensified by the behaviour of local retail investors. There is a tendency among Chinese investors to buy into IPOs – often overvalued – with a short term investment horizon, as they hope to make quick profits.
Long-term investors should, therefore, be wary of buying into hot IPOs, even though many of the recent offerings have been in small- and mid-cap stocks, in sectors likely to benefit from a new Chinese economic model, such as media, healthcare and telecoms.
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