On 1 June, MSCI added A-shares from 226 companies to its global and regional indices. While A-shares constitute an exciting playground for quant investors, practical implementation also requires taking additional precautions, says Yaowei Xu, senior portfolio manager Conservative Equities.
“To me, this is very important. It illustrates that A-shares, which used to be considered as an exotic potential source of alpha, are slowly becoming a ‘must-have’ for global investors. Although the number of stocks included by MSCI is small, this is a first step towards a USD 8.5 trillion stock market.”
“After this initial MSCI inclusion, China A-shares represent just 0.75% of the MSCI Emerging Markets Index and 0.1% of the MSCI ACWI Index, while China accounts for 15% of global GDP, 11% of global consumption and 11% of global trade. A-shares also represent 20% of global equity turnover and 11% of global equity market capitalization, making them the second largest national stock market after the US. This means A-shares remain clearly underrepresented in global equity indices, and their weight is set to increase significantly over the coming years.”
“Moreover, A-shares offer investment opportunities that are not accessible through Chinese offshore markets. Compared to Hong Kong-listed H-shares, they enable greater diversification across sectors such as consumer goods and services, health care, industrials, commodities and technology. By investing in A-shares, international investors can obtain greater and more diversified exposure to many of the fast-growing sectors.”
“Yes and no. ‘No’, because Robeco’s quantitative research methodology and stock selection models, based on proven factors, also apply to the A-shares market. And ‘yes’, in the sense that we take additional steps to ensure the quality of the data used as input for the models. It is important to make sure this data is reliable.”
“China’s economy has experienced tremendous changes over the past three decades, and so have Chinese companies. Such radical changes have translated into fast business transformation and sometimes convenient ‘shortcuts’ towards the capital markets, such as backdoor listings on the A-shares market.”
“To verify the quality of the data, we first look at its consistency. For example, if a water pump company ‘changed’ into a digital marketing company a year ago, the stock’s prior historical data is not valid anymore. Second, we take an active stance concerning corporate governance issues. If a company is suspected of significant manipulation of its financial statements, then the data for that stock is not reliable.”
“A typical illustration is off-balance sheet financing. Some construction companies, for example, generate most of their revenues through contracts owned by off-balance sheet special purpose vehicles, which are usually highly leveraged. With some creative accounting, the firm can manipulate its financial statements to make its leverage appear lower, its profits look higher, or its free cashflow seem stronger.
“Whenever this kind of dubious practice is spotted, we do not buy nor overweight the stock, to avoid any risk. These governance screenings are done by the quantitative portfolio managers, in close cooperation with Robeco’s fundamental A-shares team based in Shanghai.”
Chinese equity markets still feature very specific characteristics that really set them apart
“Definitely. Chinese equity markets still feature very specific characteristics that really set them apart and make them particularly interesting from quantitative investment point of view. Unlike most major equity markets, the A-shares market is still very much dominated by retail trading flows and foreign participation remains extremely low, close to 2%.”
“And since it remains largely underexplored by rules-based investors, prudent quantitative strategies have the potential to thrive in such a less efficient market. Our research shows that stock selection based on the factors we firmly believe in, like low volatility or value, also works well with A-shares. These factors show strong performance, both taken together and on a stand-alone basis.”
“Current quantitative emerging markets strategies already include A-shares in their investable universe. As of July 2018, our Emerging Conservative Equities strategy invests 1.5% in A-shares, while Emerging Markets Active Quant invests 0.6% and Emerging Markets Enhanced Indexing invests 0.4%. Additionally, I will be managing two dedicated A-shares quantitative strategies: Quantitative Active China A-shares and Conservative China A-shares. Clients investing in our quantitative strategies through segregated emerging markets accounts can now choose whether to invest in A-shares within their mandates, through Stock Connect or via the Robeco funds.”
“The Robeco QI Chinese A-share Active Equities strategy was launched in November 2017, aiming to consistently outperform its benchmark by taking a high multi-factor exposure to three proven return factors: value, quality and momentum. This strategy ranks the 1,000 largest A-shares and uses the same stock selection model as the Emerging Markets Active Quant strategy. Since inception, the strategy has outperformed the benchmark significantly, with a 50% targeted active share.
“In August of this year, we will also launch the Robeco QI Conservative China A-shares strategy that will aim to maximize the Sharpe ratio in the long run with a substantially lower downside risk. Both strategies invest in Chinese companies that have an A-shares listing, but can invest up to a certain amount in H-shares, as an alternative to Mainland China-listed stocks.”
“These days, the dual listed A-shares trade at a 25% premium (market capitalization-weighted) to their H-share counterparts. We choose the most efficient securities based on multiple criteria, such as liquidity differences, premium/discount, trading costs, index exposure and client guidelines. We believe that, as China’s capital account opens up further, the valuation gap between A-shares and H-shares will gradually decrease.”
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