With China in the news recently having another regulatory crackdown, Avrio's Consultant, East Bay Investment Services, provided some bullet points related to investing in stocks of companies based in China. What is happening now?
- Government reach/control has been a consistent topic surrounding investing in China.
- The recent regulatory crackdown on tech and online tutoring has several layers: exertion of more government control, concerns of data security and privacy, reduce economic inequality, national security.
- In some sense, the Chinese government is playing catch-up with technology companies that have grown by leaps and bounds and have access to large amounts of data. In some respects, this is a similar challenge to the US government, the difference being how those challenges are handled (American capitalism and democratic style of government means the US must work through issues differently from a Communist regime).
- One concern is that more regulation may be coming for other industries as well. However, we don’t know what the regulations might be, how severe, or what industries might be impacted.
- One topic of conversation has been about the VIE (Variable Interest Entity) structure. This structure has been around for several decades and was created as a way to raise capital when foreign ownership is limited. It is coming up in the news now as there are questions as to whether it is a legitimate legal structure. In speaking with firms like JP Morgan and Dimensional Funds, both firms own Chinese companies with the VIE structure in their funds and don’t believe it will be challenged as they don’t see the economic benefit for China to do so.
China and volatility
- Investing in emerging markets is more volatile than investing in developed markets. Within EM, China is also expected to be quite volatile.
- As an example of China’s volatility, Exhibit 1 (see below graph) shows the intra-year declines of the MSCI China index vs. its calendar year returns. As it shows, the average intra-year decline is 29.7%. For comparison, the average intra-year decline for the S&P 500 since 1980 is 14.3%.
- While some investors would have a “sell now, ask questions later” attitude, unless investors have a solid understanding of what is going to take place in the future, we might suggest that a disciplined rebalancing strategy that would lead to buying when everyone else is selling might be more appropriate.
China is considered an emerging market
- While China is currently the world’s 2nd largest economy, it is still considered an emerging market.
- MSCI uses measures of sustainability of economic development, size & liquidity requirements, and market accessibility requirements as criteria for assigning developed vs. EM status. While it appears that MSCI tries to be objective, there does appear to be some room for subjectivity (e.g. level of advancement of the legal and regulatory framework governing the financial market, the stock exchange, and the various other entities involved in financial markets).
- In speaking with a JPM EM specialist on the subject, he cited the “lack of separation of church and state” (or in this case, markets and state) as the main reason why he believes China will never be considered a developed market during our lifetime.
China and portfolio construction
- Depending on whether you are looking at MSCI or FTSE, China represents roughly 35-40% of EM indexes, the largest country weight by far.
- In the end, however, overall exposure to China shouldn’t have too much impact on a portfolio one way or another. If you think about it this way, let’s assume an investor has 60% of their portfolio invested in equities. Of that 60%, let’s say 13% is invested in EM, and we know roughly 40% of the EM allocation is in China, that equates to a roughly 3% allocation to China for the average investor portfolio. And remember, that 3% allocation is further diversified among many companies.
- If you unpack Chinese holdings, the vast majority are H-shares (H -shares are shares of Chinese mainland companies that are listed on the Hong Kong Stock Exchange or other foreign exchange) with a smaller percentage being A-Shares (A-Shares are stock shares of mainland China-based companies that trade on the two Chinese stock exchanges), ADR’s (certificate issued in the US representing ownership of a foreign stock) or VIE structure securities. (source for definitions: Investopedia.com)
What should be done about this?
Overall, we are not suggesting any changes to EM allocations for the following reasons:
- Investing in China is complicated, and with the uncertainty comes greater volatility. This is not new to China, so we need to expect it.
- China, in our opinion, is simply too important a player in the global economy to ignore.
- As we showed above, the exposure to China shouldn’t have too much sway on an overall portfolio one way or another.
- At some point, heavy-handed regulation could undermine investor confidence and dissuade investment in China from outside the country. We believe the Chinese authorities recognize this and it will be a check-valve on overreach.
This material is intended for educational and informational purposes only. It is not intended to provide specific advice or recommendations for any individual. Additionally, you should consult with your Financial Advisor, Tax Advisor, or Attorney on your specific situation. The views expressed in the material are that of the author, East Bay Investment Services, and do not necessarily reflect those of any market, regulatory body, State or Federal Agency, or Association. All efforts have been made to report or share true and accurate information. However, the information may become materially outdated or otherwise rendered incorrect due to subsequent new research or other changes, without notice. The author nor the firm are able to always verify the content from third party sources. For additional information about the firm, please visit the MAS Website at https://www.mas.gov.sg/ and the SEC Website at www.adviserinfo.sec.gov. For a copy of the firm's ADV Part 2 Brochure, please contact us at firstname.lastname@example.org
East Bay Investment Solutions, a Registered Investment Advisory firm, supplies investment research services under contract.
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