Postcard from China: Exploiting the market with factors

Jason Hsu, founder, chairman and CIO at Rayliant Global Advisors, speaks to ETF Stream’s editor Tom Eckett about the fundamental differences in investing in China, the huge retail market and how to take advantage of state-owned enterprises (SOEs)

Tom Eckett

Chinese dragon China

The investment landscape in China has the potential to be a logistical nightmare with political risks abound and an extremely high proportion of retail investors that can cause huge swings in share prices. However, with the potential risks come some very exciting opportunities, according to Jason Hsu, founder, chairman and CIO at Rayliant Global Advisors, who claims the inefficiencies in the market should be viewed as a professional investor’s dream.

According to Hsu, there has been an influx of quantitative investors into China over the past decade with exponents of smart beta looking to replicate the success of the Fama-French models on Chinese shores. This, Hsu described as factor investing 1.0 – effectively repeating what has already been done in developed markets and trying to implement similar factors such as value, momentum and size in China.

While there has been some success, the Rayliant Global Advisors founder said the Chinese market has started to move away from the US-centric constructs of what factor investing should be. This, he said, was factor investing 2.0 in China and focuses on risk premia that are specific to the Chinese market alone. In particular, there are two key factors at play that if exploited correctly can lead to consistent outperformance over the long term.

The first is around the high level of retail investors in the Chinese market. According to FTSE Russell, over 80% of trading on the China A-Shares market is done by retail investors. While biases rarely differ between US and Chinese retail investors, their dominance in China creates huge opportunities for professional investors in the same market.

According to Hsu, textbook strategies such as value, quality and growth remain powerful in China as retail investors lack the skill to take advantage of these fundamentals. The behavioural biases such as the propensity to gamble and use extreme leverage when investing along with their short-term investment horizons are there to be exploited.

One example Hsu gave was the creation of a factor that is based on whether a company is owned mainly by large shareholders or retail investors. When looking at this data, companies that are owned by institutional investors tend to deliver significantly higher returns than those that retail investors have bought.

“Alpha is a zero-sum game,” Hsu continued. “Retail investors are similar across the world, however, there are simply more in China. They tend to confuse what they read online with private information, for example, and tend to take on huge leverage with their investments.”

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The second factor specific to China is on SOEs. Hsu said an extremely common misconception among western investors is “all SOEs are bad companies” and a company will never be considered as a viable investment option if it is state owned.

For example, WisdomTree created a China index that excludes SOEs, the WisdomTree China ex State-Owned Enterprises index, which is defined as government ownership of more than 20% of a company. While there is logic to this on the surface as SOEs are open to government influence and have the potential to not act in the best interests of shareholders, Hsu stressed that there are ways to take advantage of SOEs, instead of simply removing all of them from a portfolio.

In particular, Hsu made the distinction between regional SOEs such as manufacturing companies involved in steel or mining and central SOEs which have more of a tech focus. The regional SOEs, he added, fit the imagery western investors have of SOEs in general in that they tend to be poorly run, give top positions to family members and can be susceptible to corruption. As a result, investors should avoid provincial SOEs when looking at the A-Shares market.

However, central SOEs are companies considered nationally important and therefore can reap the rewards of being in such a position, Hsu said. In fact, central SOEs tend to have a political tailwind as the government has named them as nationally important in order to catch up with the rest of the world, be it in tech or sustainable development, for example. As a result, these companies tend to have top management drafted in and they can be the beneficiaries of government grants and incentives.

“Western investors tend to throw the baby out with the bathwater when it comes to SOEs,” Hsu said. “However, it is important to make the distinction between provincial and central SOEs.

While provincial SOEs are open to corruption and are tied in with regional politics, central SOEs are focused on catching up with the tech leaders of the world such as the US and Japan.”

Overall, Hsu stressed the idiosyncratic nature of the Chinese market means there are countless opportunities for professional investors as long as they understand the subtle differences in culture and behaviours.

This article first appeared in the Q1 2021 edition of Beyond Beta, the world’s only factor investing publication. To receive a full copy,click here.

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