The MSCI declined to follow the FTSE Russell last week in exploiting cross-border liberalisation to include domestic Chinese A-shares into its emerging index, but further integration remains inevitable.
That leaves index investors with a series of questions on how they should think about and approach a market that remains quantifiably different from its global peers in fundamental ways.
Much like evolution of marsupials in Australasia, isolation has bred some genetic anomalies into the DNA of Chinese equity investment.
In some respects, this runs so deep that it is not immediately clear how (or even if) the traditional taxonomy of index factor investment – growth, value, capitalisation and so on – can be directly read across.
‘China A has long functioned as if it were in a parallel universe to the rest of the major capital markets,’ said Sunny Ng, head of Asia ex-Japan portfolio strategy at State Street Global Advisors.
‘Capital controls such as quotas and lock-up periods have not only hindered flows in and out of the exchange and stunted foreign investment into the Chinese domestic growth story, but have also contributed to a heavy retail skew.’
More than 90% of the domestic market remained in the hands of retail investors, Ng said. This is the inverse of the UK where the figure is closer to 10%, and the US, where it has historically run around 20%.
‘Importantly, retail buy, hold or sell decisions, particularly in emerging markets, are not necessarily motivated by a company’s fundamentals (industry, management team), or based on standard valuation metrics (price to earnings, revenue growth), versus institutional decisions,’ said Ng.
‘A case in point is that turnover in China A-shares is phenomenally higher – 500% per year from 1996 to 2002 – than it is in the US and other equity markets that are more driven by institutional investors.’
The domestic market rerating of the last 12 months has offered a real-time insight into what this can means at the margin of extremity.
While this can lead to some alarming outcomes such as the 89x forward price-to-earnings multiple currently and 8.5x price-to-book demanded by A-share IT stocks, Ng added that these anomalies can be exaggerated, however.
A recent research paper he published alongside colleagues George Hoguet and Christopher Cheung found that over the longer term (2001-13), many of the assumptions about risk premiums and factor investment that inform index strategies in developed markets held broadly true.
This was particularly strong for yield and value characteristics – which share a number of similarities – with weaker but still discernible premiums for momentum and volatility.
‘Factor-based investing may be attractive [in China] – especially portfolios tilted to yield and value,’ the State Street team said.
In common with previous research, they noted that the glaring difference between A share and other markets was in the return profile of small caps, which in developed markets are broadly recognised to command a 3-5% annual liquidity premium.
In China, this fell to 38 basis points, or to below the level it could be considered statistically significant, however.
While Ng and his colleagues did not attempt to explain the disparity, others have suggested potential causes.
Jennifer Carpenter and her co-researchers at NYU Stern School of Business suggested last year it might be due to the isolation of the domestic market, effectively bidding up the cost of funding, this would have a larger effect the greater the ratio of equity capital to capital expenditure.
‘[This] amounts to an inflated cost of equity capital, constraining the investment of China’s smaller, more profitable enterprises,’ they said.
This would suggest that greater international participation may be part of the solution as benchmark-following capital helps to arbitrage away the cost of capital.
Going back further, in 2006 Dr Jianguo Chen, senior lecturer at New Zealand’s Massey University, suggested there may be fundamental factors at play.
‘One explanation may be that investors demand an extra premium for small growth firms, given that such firms have low fixed assets, causing them to have low recovery rates in the event of default,’ Chen said.
‘State-owned enterprises (SOEs) are not efficiently managed. During the privatisation process, the same inefficient SOEs were sold to private investors.
‘Due to poor corporate governance and inefficient new investors, this can lead to the firm having higher bankruptcy risk.’