Six reasons for a strategic active approach to investing in China
Andrew Rymer
Despite the recent rally, uncertainty around the beta case for China may persist. Either way, we believe that the opportunity to generate alpha in China remains higher than in other markets.
The key takeaways
As the second largest equity market universe globally, China offers an attractive arena for active managers to demonstrate their potential skill. For those investors assessing exposure to Chinese equities, we believe adopting an active approach is as essential as ever. We summarise the case as follows:
1. There are cheap companies generating high returns on equity for investors – there are also cheap low-quality ones. You can't afford not to go active
2. A less mature market = potential for greater mispricing and opportunities for active strategies
3. Fundamentals matter in long term and markets still look inefficient; this implies opportunities for active strategies
4. High dispersion of returns creates potential opportunities for active strategies
5. Another way to see the inefficiencies is in more limited analyst coverage
6. Depth, breadth, and evolution of China equity universe = opportunities for active strategies
09 December 2024
There has been much to debate around investing in China in recent years. Macroeconomic concerns, regulatory uncertainty, and ongoing geopolitical tensions, among other issues, have given some investors pause for thought.
China is the second largest economy in the world, and has the second largest population. GDP growth may be slowing, but China remains among the fastest growing economies globally. In US dollar market capitalisation terms, China offers the second largest equity market universe in the world, behind the US. For many investors, it is hard to ignore.
In the wake of market weakness in recent years, and the various challenges facing the economy, international investor sentiment has been depressed for a long period. Despite the recent rally, valuations versus international peers remain close to their lowest in 20 years, and cheap relative to their own history. This has led many to wonder whether Chinese equities are a great opportunity, or a value trap.
This paper is not to make the case either way for investors to be fully invested, or fully divested. Instead, we argue for investors to be actively invested in China. Passive approaches are unlikely to deliver the exposures investors are hoping for, given issues of index composition, the presence of state-owned enterprises (SOEs), and ongoing universe evolution. We believe the scope for active managers to outperform is higher than in many other markets.
Chinese equities have been very weak in recent years – but it hasn’t always been that way
Chinese equities, as measured by the MSCI China Index, have declined 41% in US dollar terms since their pandemic peak on 17 February 2021 to 1 October 2024. This lags both developed (DM) and emerging (EM) markets, which have returned 41% and -9% over the same period.
Figure 3 and Figure 4 show the performance of the MSCI China index relative to broader DM and EM over the past 20 years. China has underperformed DM, and is only slightly ahead of EM, and the volatility of returns has been markedly higher. Within this timeframe though, there have been periods of outperformance of Chinese equities. Moreover, the higher volatility can create opportunities for investors.
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