Why should investors consider a greater A-shares allocation?

The key downside of sticking to benchmark indices to gain China equities exposure is limited alpha opportunities; given that the A-shares market has been a fertile ground for active managers.

Based on our calculations, the median China A-shares manager has delivered an 8% annualised excess return over the five year period to end of March 2020[1]. This is an unprecedented level of alpha compared to other global markets, and can result in a situation where the index return is negative but a manager’s return is positive.

As always, past performance is not a guide to future performance. But there are clear reasons we wrote about in our paper last year that make China A shares unique among its global peers. We highlight three of them below.

1. High retail investor participation

The defining feature of the A-shares market is the high level of participation from retail investors, who account for more than 80% of the average daily trading volume. This is in stark contrast to the H-shares market in Hong Kong SAR, which is dominated by large institutional investors.

Why is this important? As retail investors are generally less focused on company fundamentals, and often trade on rumours, it can result in stocks being significantly under or overvalued. Hence retail investor dominance provides significant opportunities for more sophisticated investors with rigorous investment processes. These investors can take the other side of a trade and be rewarded for correcting the mispricing.

For example, in early 2019, large retail flows went into ‘industrial marijuana’ and ‘red or state media’ themes. This was despite there being little fundamental backing for these themes.

The longer time horizon of institutional investors also allows them to withstand the fluctuations in prices caused by wild swings in retail sentiment.

For example, Sanhua Intelligent, a Chinese manufacturer of air conditioning and refrigerator components, has seen its share price fluctuate widely in the last few years, as it has fallen in and out of favour with speculators. Still, the share price has more than doubled since mid-2019. This is because Sanhua produces the heat exchange system used in Tesla electric cars and other next generation electric vehicles. The demand for such parts has been growing steadily, giving institutional investors the confidence to stay put as the retail crowd trades in and out.

2. Fundamentals are becoming more important as the market matures

If markets were driven solely by speculation, it would be very hard for even the best investment strategy to add value. The good news is the A-shares market is maturing, and fundamental factors are becoming more important in differentiating the performance of stocks. This is the sweet spot for an active strategy.

The charts below show the total return of the MSCI China A Index, broken down into quintiles based on return-on-equity (ROE) and price-to-earnings (P/E) ratios of individual stocks. Before 2015, there was little differentiation in the performance of either factor, highlighted by the clustering of returns. This means that investors were not rewarded for buying cheap stocks or stocks with high ROE.

In the last three years, however, there has been a visible shift with return dispersion increasing significantly. The stocks with a high ROE have outperformed the stocks with a low ROE. In the same vein, cheap stocks have outperformed expensive ones. The efforts of fundamental investors are now being rewarded by the market, as valuations and corporate profitability are gaining a greater influence on returns.

Returns in the A-shares market are now more driven by fundamental factors:

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