Craig Farley, Investment Manager at Ashburton Investments.
China’s equity markets and absolute returns are rarely considered synonymous by market observers, yet that is precisely what Ashburton Investments is seeking to deliver with its latest specialist equity offering, the China Optimal Equity Solution (COES).
Conceived during the aftermath of the global financial crisis, COES harnesses market timing and decades of successful investing in China to deliver a unique concept; two stage, rules-based access to one of the world’s most exciting long-term opportunities for investors worried about volatility and significant drawdowns.
Source: Bloomberg, 31 July 2017
A glance at the risk-adjusted returns of major indices over the past twenty years lends weight to the argument that China has been a burial ground for buy-and-hold investing. Adjusted for fees, an investor parking their money in an offshore China market tracker in 1992 would still be in negative territory today while being subjected to an annualised volatility level of nearly 30%.
Looking at equity market rallies of over 20% during the same period reveals a strong positive movement, including between May 2004 and October 2007 which generated over 500% in US dollar returns. Unfortunately, these spectacular upside moves have been punctuated by severe market corrections, leading to periods of enormous wealth destruction and capital losses.
Source: Bloomberg, 31 December 1992 to 31 July 2017
Source: Bloomberg, 31 December 1992 to 31 July 2017
For Craig Farley and Luke Gale, investment managers of the COES strategy, the frequency and magnitude of China’s bull and bear markets creates a fertile environment for an absolute return strategy.
So how did the concept materialise?
‘’We were at the coal-face managing Asian equities throughout the GFC, explains Farley. ‘’Although sub-prime US mortgages and leverage in Western property markets were at the epicentre of the crisis, China suffered a 74% peak-to-trough drawdown, the worst performance among major market indexes. The environment was one of unmitigated panic.’’
Innovation through understanding
The experience provided valuable lessons to both managers and demonstrated the importance of liquidity, risk control, and portfolio flexibility to preserve capital at times of heightened market stress.
This began an extensive period of intensive research and development. The objective: to cultivate an equity strategy for China that seeks to capture the lion’s share of upside market potential while mitigating exposure to severe corrections.
‘’Optimism is embedded in every equity investors’ DNA and there is an inbuilt fear of ‘missing out’ on upside moves, but markets need to pause for breath, often deeply’’, says Farley. The project was undertaken in conjunction with Ned Davis Research Inc., a world-class research hub based in Florida, USA that specialises in data programming, financial information delivery and systematic trading capability.
‘’Our relationship with Ned Davis extends back over 15 years indicating a high level of trust’’, explains Gale. ‘’The custom research team have been instrumental in ensuring sufficient rigour around testing our concepts and ideas, whilst ensuring the data utilised in our strategy is clean, consistent, reliable and secure. The result is a high degree of confidence in our process going forward’’.
Turning to the strategy itself, the entire COES investment process is underpinned by two independent proprietary models and the flexibility to move assets 100% to cash if required. A market timing model uses aggregate pricing data from the exchange to gauge the underlying health of the Chinese equity market at the index level and determines the allocation between equities and cash. The allocations are binary, either 0% or 100%. ‘’All we are trying to ascertain is whether the current environment is conducive to positive equity returns going forward’’, states Gale. ‘’If the picture is bearish, we don’t need to be in there swinging for returns, it’s as simple as that’’.
Assuming the model is bullish (100% equity allocation), a stock selection screening model selects the securities for portfolio inclusion.
‘’Liquidity is paramount’’, explains Farley. ‘’Our experience has shown that idiosyncratic stock risk rises sharply as you move down the market-capitalisation curve in China’’. The strategy only invests in the 150-200 companies that comprise the MSCI China universe; this gives investors access to c.85% of China’s equity market by capitalisation, whilst ensuring that all portfolio stock positions can be exited smoothly and with minimal slippage to the portfolio. MSCI’s additional filters for potential inclusion along with conformity to Hong Kong reporting standards adds an additional layer of comfort when screening potential candidates.
Source: Ashburton Investments, MSCI, 15 October 2015 to 31 July 2017
Following a successful extended period of paper-trading, the strategy was seeded by the First Rand Group and has been run live as a privately managed account since October 2015.
The COES strategy has returned 29.4% since launch but it is the risk-adjusted returns that really stand out. The COES strategy has had over a third less equity at risk than the benchmark while enduring a far smaller maximum drawdown and generating a Sharpe ratio 0.3 higher than the MSCI China.
“It is still relatively early days, but the pleasing thing from our perspective has been that outcomes are consistent with strategy expectations despite testing market conditions’’, says Farley. China’s equity market return profile in 2016 - a clear 'W' shape - is a prime example of how quickly sentiment can shift in China.
‘’Occasional whipsaws are a consequence of the systematic strategy we adopt. However, our natural position is to worry about the downside risk rather than how much we can make on the upside. We are fixated on playing excellent defence’’, explains Gale.
Having zero market exposure from the middle of November 2016 into year-end served the COES strategy well. A new buy signal was initiated on 11 January 2017 and the portfolio has remained 100% invested since then, generating solid returns.
Source: Bloomberg, 15 October 2015 to 31 July 2017
COES is initially being offered as a bespoke portfolio to sophisticated investors seeking to access China, but extends to absolute return mandates given the risk-adjusted profile of the offering. Ashburton Investments are targeting UCITS-wrapped fund solution next year. The managers emphasise that the MSCI China universe acts as the lever to generate positive returns through the cycle. COES is not a relative return product; the risk and return profile will vary significantly from the index as seen above.
Too big to ignore
One thing is certain; China is now too big to ignore. The underlying structural shift taking place in the economy alongside a desire from Beijing to better regulate and deepen the country’s capital markets will almost certainly ensure opportunities and risks in the years ahead. For the COES strategy, having a high degree of flexibility to manage capital allocations and aggregate portfolio risk through the cycle is what differentiates the product from typical offerings. Looking at the statistics, it is hard to disagree.
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