Why China appeals to good investors

I wrote about the new enthusiasm for Chinese equities among the world’s equity strategists in the FT earlier this week. There are all sorts of drivers behind the shift – that the market is not totally correlated with developed markets (everyone needs diversification); that China is opening its capital markets to the world; that as, Gavekal put it, China is “the only major economy in the world today where local policy makers are not actively pursuing the euthanasia of the rentier” (ie, real bond yields are actually positive).

But one of the more interesting points on this market was actually made last year – pre-pandemic – by Gavin Ralston and Krisjan Mee of Schroders. It is partly thanks to the participation of enthusiastic, but not fundamentally driven retail investors (in 2018, 86% of A-share trading was retail).

The Chinese A-shares market is wonderfully inefficient – something that makes it “fertile ground for active managers”. Over the five years to March 2019, when this paper was written, the median active manager in China A shares was able to earn an annualised return over the market of 6.3% after fees. This is, say Ralston and Mee, “an exceptional figure by global standards”. Elsewhere median excess returns have been either close to zero, or in some cases (the US being the standout example) negative (after fees the average manager does worse than the index).

Also of interest are the figures for passive funds. Most developed market exchange-traded funds (ETFs) tend to underperform the indices they track by their management fee – which makes sense. Not so for China A shares. The largest A shares-tracking ETF has regularly underperformed the index by significantly more than is implied by its expense ratio.

We have written a lot here over the years about whether one should invest passively or actively. We’ve made it clear along the way that the answer is partially market dependent. You can’t expect an active manager to have much luck outperforming in the global large-cap space. You can expect him to if he is investing across all market capitalisations in Japan or India. And it seems you most certainly can if he is investing in China A shares. One reason, then, to hold a stand alone allocation to Chinese equities (the political nose-holding required aside) is that China is one of the few markets in which good investors can have a hope of making good returns “even if the market as a whole does not deliver”.