Is it possible to reduce the risk from investing in Chinese equities without divesting from the market altogether? Northern Trust Asset Management’s Michael Hunstad believes so.
The Chinese economy is in a precarious position.
The shift from an export and investment-driven growth model to one where private consumption is fueling the majority of economic activity has not been progressing exactly smoothly.
Demographic headwinds from an ageing population after decades of the one-child policy are weighing on future growth, while the lack of a social safety net makes consumers cautious about their spending.
The recent downturn in the Chinese property sector, accompanied by a large debt overhang, has put further strain on consumer confidence and the ability of the government to spend its way out of the economic malaise.
On top of this, China is facing a tense geopolitical situation.
It has been more than six years since the start of the Sino-American trade war, which saw former president Donald Trump introduce steep increases in US tariffs on Chinese imports.
The wars in Ukraine and Gaza have only added to the tensions and it is unlikely to see any improvement in international ties soon.
All of this has made institutional investors wary of investing in Chinese equities.
In the last six months alone, divestments have been unusually high, Michael Hunstad, Deputy Chief Investment Officer and Head of Global Equities at Northern Trust Asset Management, says in an interview with [i3] Insights.
“There definitely have been more asset owners that have divested from Chinese equities. In our experience, it is pretty unusual to see the quantity of divestment that we have seen in the last six months,” he says.
You can look for higher quality, lower volatility Chinese equities, which have done exceptionally well relative to the Chinese benchmark. There is a lot of potential in buying stocks with good financials, good balance sheets, good cash flow and lower risk
But in the Australian regulatory context, divesting from Chinese equities comes with its own risks, for some superannuation funds potentially existential ones.
The ‘Your Future, Your Super’ performance test penalises funds for taking on too much tracking error and divesting completely out of Chinese stocks would certainly increase tracking error by a significant margin.
Hunstad proposes an alternative way to manage the risks from investing in Chinese equities. He argues that investors can use a factor-based framework to identify stocks that have an asymmetric beta profile, thereby offering some protection against the downside, without giving up too much on the upside.
“You can look for higher quality, lower volatility Chinese equities, which have done exceptionally well relative to the Chinese benchmark. There is a lot of potential in buying stocks with good financials, good balance sheets, good cash flow and lower risk,” he says.
These stocks have been performing well, because the Chinese market has a relatively high participation of retail investors. These investors tend to go for the more risky trades, leaving opportunities for patient capital to invest in businesses with more sustainable business models.
“When you think about buying low risk, higher quality stocks, it’s kind of counterintuitive that you should get paid more for that. Most people think that investors are buy-and-hold investors, that they’re in it for the long term, they’re probably a little bit risk averse.
“But we see a huge amount of evidence of risk-seeking behaviour in equity markets, meaning investors aren’t looking to buy and be in their positions for two or three years and make a 10 per cent return.
“It’s about buying over the very short term and trying to make a 30 or 50 per cent return. We call that lottery ticket-seeking behaviour, where you’re looking for a very quick payoff.
“When that happens, investors tend to bid up the price of stocks that are high volatility and lower quality because they’re expecting a bounce back, often to the point where these stocks no longer have a good return expectation.
“And perhaps that is nowhere more prevalent than in the emerging markets, where you just have a lot of risk-seeking behaviour that will positively influence the performance of a lower volatility, higher quality position,” he says.
Skewing the portfolio towards higher quality stocks can be done without increasing the tracking error too much, Hunstad says.
“You can get a very meaningful exposure to quality with a relatively low amount of tracking error to the underlying benchmark. So we’re talking 50 to 100 basis points or so.”
Investors might also want to reduce their exposure to companies that are of low quality, including certain state-owned enterprises.
“A lot of our clients are reducing or eliminating their exposure to Chinese state-owned enterprises, which have the least transparent data associated with them. That’s part and parcel to a quality orientation as well,” he says.
Asymmetric Beta
Using volatility as a measure of risk can be misleading. After all, stocks that increase rapidly in price are highly volatile, but this is not necessarily an issue. The problem is when they come down again.
“Nobody cares about volatility when markets are going up; they only care when it’s going down. So when you think about controlling risk in your portfolio, what you should be concerned with is what more of your downside risk is versus your upside risk.
“And those two can be very different,” he says.
Investors should make this distinction when investing in stocks, because it is possible to find stocks that move less violently in times of crisis than the market, but still maintain a relatively strong upside potential. Hunstad refers to this concept as asymmetric beta.
If I simply lower my risk, then I'm going to cut off my downside equal to cutting off my upside. But if I have an asymmetric beta, which is what we're trying to achieve, then you have a lower beta on the downside than you do on the upside. And if you can do that, you can actually outperform while cutting your tail risk
“You can protect on the downside and participate in the upside, that is really what causes low volatility stocks to do well. If I just have 0.7 beta, I’m going to have 70 per cent of the downside and 70 per cent of the upside. I’m probably not going to make a lot of money doing that,” he says.
“If I simply lower my risk, then I’m going to cut off my downside equal to cutting off my upside.
“But if I have an asymmetric beta, which is what we’re trying to achieve, then you have a lower beta on the downside than you do on the upside. And if you can do that, you can actually outperform while cutting your tail risk,” he says.
Hunstad doesn’t use derivatives as an insurance against downside risk as this would be a relatively expensive way to implement protection. Instead, his approach is all about stock selection.
“There are no derivatives [in this strategy], no overlays; it’s long only, cash holdings. You can do a really nice job of creating that asymmetric risk profile just by trading those securities,” he says.
“If you’re using derivatives, derivatives tend to be very expensive and especially when volatility and markets are high, protection can be very expensive. So in a sense, this is the cheapest protection you can get because you’re not really paying for it,” he says.
Style Tilts
Reducing your exposure to Chinese equities means that your emerging markets portfolio is more heavily exposed to cyclical sectors, including financials, materials and energy, and less to secular growers.
But despite this reorientation, the portfolio does not end up taking on a value tilt, Hunstad says.
“You would intuitively think that it would, right? So you’re going into the more value-oriented sectors. You’re going away from the more growth-oriented sectors.
China, relative to other emerging market countries, is such a screaming value play in and of itself, irrespective of the sector composition, that removing China actually makes your portfolio a little bit more exposed to growth, at least purely from a multiples perspective
“But that assumes all else is equal, which is not the case here because China, relative to other emerging market countries, is such a screaming value play in and of itself, irrespective of the sector composition, that removing China actually makes your portfolio a little bit more exposed to growth, at least purely from a multiples perspective.
“So Chinese stocks are just really, really cheap on basically any multiple that you look at. If you remove China, what you get that’s left over, EM ex-China, has a higher multiple.
“If you use that as your definition of growth versus value, you’re actually going to end up with a little bit more growth-oriented portfolio, even though from a sectoral composition, classically, you would have had a bit more value exposure,” he says.
Index Changes
The volatility in the Chinese market meant its composition has changed quite a lot in the past 12 months, which is reflected in the recent quarterly rebalance of the major indices. MSCI’s Emerging Market Index deleted 66 Chinese companies from the benchmark in February, a relatively high number compared to other periods.
The removal of these stocks decreased China’s overall weight by 0.3 per cent to 25 per cent in the emerging markets index. Although a relatively small decline, China has been losing weight in the index since late 2020, when its weighting peaked at more than 40 per cent.
Yet, Hunstad says the recent rebalance exercise does not indicate trouble.
“I wouldn’t call it a red flag or anything. 66 is quite a few, but at the same time, we’ve seen some pretty substantial outperformance of China,” he says.
In fact, the MSCI China Index outperformed the MSCI Emerging Markets ex-China by 3.1 per cent over this period.
Interestingly enough, the total number of companies that were deleted from the MSCI EM Index, 81 stocks all up, outperformed the companies that were added to the index over the announcement to effective date period.
But Hunstad is quick to point out that this wasn’t the case when looking at Chinese companies.
“Yes, the deletes outperformed the adds, but they did not outperform the China component of the EM benchmark, and most of the deletes were from China. So if you look at it a different way, the deletes from China actually underperformed the Chinese portion of the benchmark,” he says.
“The idea right now is, even though they’re very, very cheap, you don’t want to hold low-quality Chinese securities. Those are the ones that are going to be really at risk and, quite frankly, are at risk of being eliminated from the benchmark as well.
“Among the 66 deletes, many of those companies were relatively low-quality securities,” he says.
This article is sponsored by Northern Trust Asset Management. As such, the sponsor may suggest topics for consideration, but the Investment Innovation Institute [i3] will have final control over the content.
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[i3] Insights is the official educational bulletin of the Investment Innovation Institute [i3]. It covers major trends and innovations in institutional investing, providing independent and thought-provoking content about pension funds, insurance companies and sovereign wealth funds across the globe.