The summer of 2015 was a balmy one until “Black Monday.” Only two weeks before, I had been invited to the launch of a China A-shares ETF product. It was indeed unfortunate timing–that product has since closed.
After Black Monday, fund flows into China-themed funds and ETFs in Europe atrophied. Thomson Reuters Lipper data reveal around €5 billion of net outflows from UCITs China-themed funds since that correction. However, Q1 2018 was a very good quarter and showed a considerable reversal of trend, with nearly €1 billion of inflows over the period. That was despite lacklustre performance over the same period.
Suddenly, there is a bit of a buzz about China. Is the trade war on or off? What are the implications of its US$30 trillion of debt, and how will the inclusion of A-shares in MSCI indices impact the market?
Fund flows and fund launches
Currently, there are some 120 UCITs China-themed funds available for sale in Europe with around €27 billion of assets under management. That is approximately the same level of assets in these funds as around the time of the Black Monday correction. Despite poor recent data, this figure represents an increase of around 50% in total assets since 2010.
These flows are relatively small, however. To illustrate perspective, the total pan-European fund market AUM is around €10 trillion, and net inflows for 2017 were nearly €800 billion.
Despite the persistent outflows of UCITs China-themed funds, fund launches have been surprisingly resilient, with around 30 new funds and a handful of ETFs coming to market since August 2015. Although they have not collected many assets, they may well be poised to do so.
Exhibit 1. Performance of Lipper China Fund Categories From Black Monday Until May 24, 2018 (% in Local Currency)
Much ado about A-shares
The imminent inclusion of A-shares into the MSCI indices in June 2018 is gathering much interest. Exposure to the Chinese domestic economy, the shares’ low correlation to the U.S. dollar, and a broader investor base are viewed positively, but many fund managers urge a balanced view.
Gary Greenburg, head of emerging markets at Hermes Investment Management, believes selectivity is key: “The China A-share market contains thousands of companies, of which a number are interesting, a number are undervalued, and a small number are both interesting and undervalued.”
China: Passive or active exposure?
China faces the considerable macro headwinds mentioned above. However, Q1 2018 revealed strong performance at the stocks level. Research from Prusik Investment Management shows 45% of the China-domiciled stocks on average reported revenue and profit increases of 17% and 25%, respectively, for the period.
Many fund managers and analysts see the Chinese market as ripe for active stock pickers and warn against the indiscriminate exposure to already expensive companies that ETF purchases potentially lead to.
Monitoring stock ownership reveals clues as to the role passive ownership may have in affecting stock prices. From the most recent Thomson Reuters Eikon fund shareholders report for Alibaba, of the 20 top fund holdings, 4 are passive funds, whereas for HSBC, of its 20 top fund holdings, 14 are passive funds. This dynamic will become increasingly marked as more China stocks make their way into popular indices.
The largest current holding in the iShares MSCI China A ETF, is Kweichow Moutai Co Ltd. This is currently trading on a PE multiple of 30.5x (against a peer group average of 21.5x). A good equity analyst will be able to tell you if this stock is well priced however, its current fund shareholders report reveals of the 20 top fund holdings, 7 are passive vehicles. Post June, this number will undoubtedly increase.
What does 2018 hold for China stocks?
If the Lipper Q1 fund-flows data for China set the pattern for the rest of the year, then summer 2018 could potentially be good for the region. Macro noise will create uncertainty, but it seems many Chinese companies are getting themselves into good shape. Controls on leverage should prevent the amplified volatility we saw around Black Monday.
There is a large disparity between Mainland China-listed shares, which constitute around 23% of global traded value but which will weigh in with the MSCI in June at under 2%. This is certainly a supportive long-term dynamic. However, it appears this is a region where blindly buying shares through a passive strategy is potentially riskier than using other strategies.
For many investors ESG and governance are key factors that would preclude many China shares. As active foreign investors and institutions gradually become more influential, this could improve governance, but only if China itself is prepared to share the love with minority investors.
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