The investment environment in China is in a transformational state, a condition that is contributing to some misperceptions about the market by U.S. investors, even as they seek more assiduously now than ever to understand the opportunities there and the best ways to access them, according to Douglas Eu, managing director, and CEO of Allianz U.S., speaking last week at Markets Group’s 6th Annual Texas Institutional Forum in Austin. “We believe that investing in China A shares actively is a way for us to generate alpha,” he asserted.
Eu joined Allianz as CEO of Allianz Global Investors Asia Pacific in 2006, and was named to his current role in 2016. He began his investment career in 1990 and began investing in China in 1992. Over the last several months, he has spent time with institutions and consultants discussing how best to access various investments in China.
“If you start to listen to how institutional clients around the world talk about emerging markets and China, I’ve found that the debate goes back to looking at China like we look at the United States, and I’m not sure that this is always appropriate. I think the Chinese markets today—especially the A-share market—is a market that’s roughly the size of Europe that’s largely un-invested in by foreigners. So, in a way, to some in the U.S. it’s almost like a private market; it’s not a private market, but it seems that way if you haven’t yet bought it,” Eu said.
For many years the Chinese government has telegraphed important planned changes in successive five-year plans
Eu began investing in China before the nation had stock markets, he said, driven by the country’s growth story, which he characterized as ‘spectacular’. “All we were doing is looking at what the Chinese government was saying, and what they were able to do,” he said, explaining that for many years the Chinese government has telegraphed important planned changes in successive five-year plans. “For many years, they’ve emphasized all the changes you need to know. And as investors, we said ‘okay this government has said what they want to do, and they’ve continued to deliver.’ So, we began looking at China in the eighth five-year plan, which covered the period 1991 -1995.” That plan was one of the first in which the Chinese government’s focus on economic growth became evident, according to Eu. The plan included the development of economic zones like Shenzhen, as well as reforms of state-owned enterprises and efforts to introduce market forces into China.
While building the A-share market, Chinese authorities also recognized that it needed to introduce professional management to the industry. So, in 1998, China issued 10 fund management company licenses (allowing the firms to sell pooled funds to the public). The market expanded to include foreign players in 2003, allowing them only limited shareholdings, however. “So, there was really no control. I joined the board of one of those companies at that stage and that began a journey of education. And whilst I’ve seen the amount of specialization improve significantly in China, it’s still not at the same level as institutional investment in the U.S.; I think it will get there, but it’s taking a long time.”
We believe that investing in China A shares actively is a way for us to generate alpha
Why is China an attractive investment?
Eu characterizes the diversification benefits of investing in China as “one of the free lunches in our industry.” In general, the correlation between China A-shares and other widely held indices has been low and Eu believes it will stay low. (See exhibit 2.) One reason he believes this is economic and corporate globalization, in which, he argued, Chinese companies have largely not participated. “The U.S. is a country with some of the best companies in the world—companies that have grown internationally, some of the largest companies in the world. These are an exception everywhere else in the world.”
Eu explained that in that context, China A-Shares are attractive, “because they sit in a market that is very large and very un-globalized. Companies that thrive in China are generally companies that we don’t hear of here in the U.S. And even the ones that we do hear of, we don’t see them in our marketplace. I think if you look at China A-shares, ninety percent or more of their revenue is derived from the Chinese market. They are one of a very few countries in the world that has a market that is attractive enough for them to grow their business without having to internationalize. That’s not what you see in lots of the other emerging markets.”
China’s market participation is gradually shifting from largely retail dominated to institutionally-dominated as China develops its market structure, according to Eu. This will gradually reduce volatility, he predicted. China’s A-share market reflects the fastest growing sector of China’s new economy. “So, if you take a look at where the stocks are represented, you can see that if you want to get access to the larger part of the Chinese economy, where the growth is happening over time, you really need to think seriously about how you incorporate Chinese A-shares into you asset allocation,” he asserted.
Beijing’s track record of managing economic growth
The Chinese government has demonstrated that because of the unique structure of its state-owned capitalist system it has a lot of control over where growth is going to happen. It signals this with its five-year plans, Eu said. The most recent five-year plan highlighted growth in key strategic area. “But they made sure that their growth targets are not just about growing companies, they’re also about making sure that the growth is inclusive, that the individuals in the Chinese markets also grow. And I think that is part of a much broader strategy that the Chinese have for not just growing the economy, but growing the consumer sector of that economy. Which we think makes it very attractive,” Eu said.
When people ask Eu what Chinese growth means to him, he said he thinks about when he was in Norway last Christmas with his family: “I remember getting out of the plane at the airport and walking downstairs to luggage collection and being surrounded by 150 Chinese at the airport. And I was like ‘What country am I in?’” he said. He views the experience as a tangible expression of what China’s economic growth has meant for China’s population in general, adding that the growing number of Chinese students that study in the United States is another example of the nation’s widening economic prosperity.
How should US institutions invest in the Chinese A-share market?
Though he believes emerging markets indexes have historically guided investors’ thinking about allocations to China, “We started the other way around. We asked ourselves ‘why does this thing work for us?’ Then we went to look for benchmarks to do it. I think if you have ever been to China you can see the visible expression of the growth opportunities by looking at what it’s done with infrastructure across the country. When I started investing in China in the early 1990s, there was no highway infrastructure system. But the Chinese government recognized that if they were going to promote growth—at that stage they were an export-growth model—they needed to build roads.
In the wake of the global financial crisis, the Chinese government needed to spend money to drive its economy. It focused on new technology. “Today they’ve built high-speed rail lines that are phenomenal. The first time I sat in a high-speed rail line from Shanghai, I really began to understand relativity, because we were going along at 200-plus miles per hour and the cars on the highway looked like they were standing in a parking look. So, if you look at what that has allowed in terms of transportation across the country, I think there are phenomenal opportunities that the Chinese government has built in there.”
Factors to consider in China Investing
According to Eu, China A shares offer exposure to significantly different sectors than the offshore China market–they offer greater exposure to smaller and mid-cap companies, for instance.
The existing weighting of China A-Shares—particularly within the emerging market indexes—is too low, Eu asserted. Today, the MSCI [Morgan Stanley Capital International] has decided to put a five percent factor on 233 of the largest China A shares, Eu said. This produces a weighting in the emerging markets index of 80 basis points. “If you increase that weighting to 100 percent of the largest companies, that weighting, within just the emerging markets, increases to 17%, and if they included all the companies it would increase to 28%,” he said. (see exhibit 5).
The Chinese stock market is starting to become the most important part of the emerging market index, Eu declared. “But, in lots of conversations I’ve had with clients, if we started today and looked at all the emerging markets and asked where would you be putting your money today, I’m not sure we would start with emerging market indexes. You might start with a different weighting somewhere else, with China as a discrete weighting.”
The MSCI All Country World Index’s inclusion factor has Chinese A-shares representing 15 basis points, Eu said. “As investors, we know that a 15-basis-point weighting in our portfolio isn’t going to make a huge difference to us. So, we don’t think that following the index providers in this case makes sense. We understand why they are doing it, it’s completely rational from their perspective, but it shouldn’t drive your investment policy.”
Finally, Eu said, investing in China A-shares demands an active approach, and even the median managers can vastly outperform the benchmark, producing alpha of 21% over a year.
“I’ve learned a few things from my failures. Number one, if you look at the Chinese market, the Chinese economy is not like the U.S., It’s state-owned capitalism. I remember investing in bank shares there when they first came out in the late 1990s. One of the things that we talked about then was the high percentage of non-performing loans on their balance sheets. Their levels of non-performing loans would have scared us off anywhere else in the world. Here in the U.S. you would have said those banks are bankrupt.”
On hindsight, Eu said, he understands that the level of underperforming loans was not a huge factor. “The reason it didn’t matter was because of state-owned capitalism, where the government controls the policy. It owned large chunks of the banks and it owned the institutions the banks were lending to. So, you never had a liquidity problem. With some quiet conversations, you could extend out loan payment periods. So you could avoid the liquidity events that caused a lot of the pain that we saw here in the global financial crisis. So, for me, whenever I think about Chinese companies, I always say they are subject to the same kind of free market forces you see here in the U.S., because the government controls so much of the economy and the financial outcome for companies.
Mr. Eu is Chief Executive Officer US and a managing director with Allianz Global Investors, which he joined in 2006. He is a member of the firm’s Global Executive Committee and US Executive Committee, and was previously Chief Executive Officer Asia Pacific. Mr. Eu has more than 30 years of investment-industry experience. Before joining the firm, he worked at J.P. Morgan Asset Management (and predecessor entities, including JF Asset Management) where he held several positions, including Chief Executive of JF Funds Limited; investment specialist for Greater China (and previously Asia, including Japanese and Indonesian equities); and equity analyst covering the Hong Kong real estate sector. Mr. Eu has an A.B. in economics from Vassar College and an M.Sc. in business studies from London Business School. He served as a member of the advisory committee of the Securities and Futures Commission from 2007 to 2013.