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The changing nature of China’s markets

As China’s markets open up to the world, they present new opportunities to invest in a fast-growing, innovation-driven environment. Established just over two decades ago, China’s A-share markets have expanded rapidly and are now second only to the United States in terms of market capitalisation. Yet they remain largely overlooked by international standards, with only around 2% of that market capitalisation owned by overseas investors. This is set to change when MSCI adds more than 200 large-cap China A stocks to its benchmark emerging markets index in mid-2018.

The inclusion of Chinese shares in more global indices, as well as the development of schemes like Stock Connect, will give more investors access to companies that drive growth on the Mainland but are typically underrepresented in the Hong Kong and ADR markets, the standard international routes to Chinese equity. With a relatively low correlation to global equities, Mainland markets can help investors diversify their portfolios with reasonably valued shares that have the potential to deliver solid, long-term returns.

Innovation-led growth

Many of the most promising investment opportunities lie in China’s emerging industries. The country’s e-commerce sector, now the world’s largest, is a good example. Aided by growth in domestic consumption, the sector is projected to account for a quarter of retail sales by 2020, up from 17% in 2017.1 Or take biotech, which is targeted to exceed 4% of GDP by 2020, supported by more than US$100  billion in investments.2 China is also betting on a “robot revolution” to counter its ageing population and sustain growth by automating large swathes of its manufacturing sector.

Ambitious government-led initiatives also are expected to provide a top-down boost to investment and corporate bottom lines. Law firm Baker McKenzie estimates projects linked to the Belt and Road Initiative will be worth US$350 billion over the next five years. The Greater Bay Area project is set to boost industries like manufacturing, shipping and finance by pooling the resources of 11 cities in the Guangdong-Hong Kong-Macau region, which boasts a combined GDP of US$1.4 trillion, according to a survey by KPMG China and the Hong Kong General Chamber of Commerce.

The benefits of a holistic approach

To unlock the full potential of Chinese equity, active, holistic investment spanning the onshore and offshore markets is likely to yield more results than a strategy separating or relying exclusively on A-share and offshore allocations. Such an approach enables investors to dynamically balance allocations across industries old and new, selecting from a vast universe of shares listed in Hong Kong, Shenzhen and Shanghai, and US-listed ADRs. Mainland shares also provide institutional investors unique opportunities to leverage the inefficiencies of a largely retail-driven market, such as frequent sector rotation and excessive price swings.

That said, Mainland markets also present unique risks. MSCI’s inclusion decision came only after years of efforts to address global investors’ concerns about stock suspensions and limits on repatriation of funds. Volatility driven by short-term views, poor corporate governance and a paucity of reliable data are all persistent issues.

In such an environment investment strategies can’t be driven by standard third-party sources of information; they need to be supported by a deep local presence and expertise. Portfolio managers should be Chinese speakers who through years of experience have become intimately familiar with the dynamics of the local markets and the ways they have developed.

These managers should be capable of going beyond standard analysis, tapping their extensive local networks to conduct on-the-ground, independent, grassroots research into industry trends and engage in high-level discussions with the management teams of the firms they invest in. They should conduct regular field trips to local facilities, and carefully evaluate disclosure practices to assemble a portfolio of high-potential companies they know inside and out. This is ‘active’ investing in the most literal sense of the word.

1 PwC; “eCommerce in China – the future is already here”; 2017.

2 Nature: International Journal of Science; “Biotech booms in China”; 17 January 2018.

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