China A-shares remain underrepresented in investors’ portfolios. Find out why you can’t afford to miss out on the opportunities in China’s onshore equity market.
Three reasons to consider investing in China A-shares
Despite being one of the largest and fastest growing economies in the world, we believe investors do not have enough exposure to Chinese equities, in particular onshore Chinese equities. We’ve found that the average international investor’s total China exposure is 4.6% of its total assets1. A large part of this is likely to be in offshore Chinese equities through emerging market (EM) equity strategies benchmarked to the MSCI EM Index. While China accounts for around 34% of the MSCI EM Index, the weight of onshore Chinese equities (China A-shares) is only about 5%. However, judging from prior examples of Taiwan and Korea, we expect that onshore Chinese equities will continue to rise in global indices.
Drawing on the framework from our Long-Term Capital Market Assumptions (LTCMA), we explore three key reasons why investing in China A shares could help improve risk-adjusted returns.
1. We see onshore Chinese equities delivering high single digit annual returns over the next 10 to 15 years
In our 2022 LTCMA, we lifted our long-term annual returns forecasts to 6.6% in local currency terms and 8.2% in US dollar terms (6.9% in euro), up from 6.3% and 7.5% (6.1%) respectively last year2. These are considerably higher than our developed market equity return assumptions.
The upgrades to our forecasts were driven by a greater rotation towards new economy sectors and the expectation for significant international and domestic investor flows.
Among the key factors that could further affect our long-term assumptions for Chinese assets are: the pace of structural reforms; policies seeking to rebalance efficiency and equality in the economy; liquidity; and the external environment.
2. Onshore Chinese equities offer clear diversification benefits
Chinese onshore equities have historically had a low correlation to other assets, offering investors potentially attractive portfolio diversification opportunities. Correlations will likely rise as foreign investor participation in the Chinese market rises however, we believe correlations will remain low relative to developed market assets, given China’s distinct economic and policy cycles.
Many investors do not differentiate between offshore (Hong Kong-listed H-shares and US-listed ADRs3) and onshore A-shares. 2021 was a stark reminder that that these markets can diverge. Offshore equities were hit by concerns over forced delisting of ADRs – onshore equities rarely have ADRs – and regulatory change that primarily impacted mega-cap offshore stocks. In contrast, onshore equities delivered positive returns, albeit more muted than global equities, as China tapered its stimulus. With China now set to ease policy at the margin, while the Federal Reserve tightens policy, we think China could once again diverge from the global business cycle.
We modelled Chinese equities’ return projections, their correlation to other markets and volatility risk based on historical data. A dedicated allocation to A-shares of up to 10% over and above current benchmark index weights would result in a more optimised portfolio with an improved efficient frontier — which means A-share investors can expect higher returns for each given level of additional risk. Put another way, with global equity correlations high, not having adequate onshore exposure may represent an opportunity cost in terms of portfolio diversification*.
Exhibit 1: China A shares offer investors diversification opportunities
Source: MSCI, J.P. Morgan Asset Management; (Left) FactSet, Standard & Poor’s. Correlations are based on monthly price return data in U.S. dollar terms for the period 02/28/2007–01/31/2022. The efficient frontier returns and volatility are based on the J.P. Morgan 2022 Long-term Capital Market Assumptions (LTCMA) estimates. Guide to China. Data are as of January 31, 2022.
3. Onshore equities provide exposure to China’s increasingly consumer-led economy
China’s equity market is shifting towards sectors that are benefiting from its transition to a more consumption and innovation driven economy, and away from sectors that are more reliant on investment and exports. The beneficiaries of China’s economic transformation include consumer goods, technology, health care and high end manufacturing. We expect these shifts to continue, potentially offering China A-share investors more exposure to these high growth sectors compared to emerging markets overall.
The MSCI China A Index also gives considerably greater exposure to small and mid-cap stocks that typically service the domestic economy, with close to 25% in companies under $10 billion market cap, compared with close to 16% in both MSCI China and MSCI EM. That has meant they are more sheltered from US-China tensions, and less subject to Chinese regulatory interventions which have targeted mega-cap companies that are generally listed offshore.
Conclusion
There are significant investment opportunities in the onshore market in China and increasingly more ways to access them. The China A Research Enhanced Index Equity (ESG) ETF provides exposure to onshore Chinese equities by exploiting stock specific insights with index like characteristics and robust risk management. As we will explore in our next paper, ‘Benefits of China A-Shares for active ETF investors’, A-shares are deep, liquid, and inefficient; a fertile environment for well-resourced managers equipped to manage environmental, social and governance (ESG) risks.
*Forecasts are not a reliable indicator of future performance. Diversification does not guarantee positive returns and does not eliminate the risk of loss.
1 Source: J.P. Morgan Asset Management; (Left) CEIC, People’s Bank of China, Shanghai Stock Exchange, Shenzhen Stock Exchange; (Right) Bloomberg, MSCI, World Bank.Share of EM GDP is for 2020 and is calculated as Chinese nominal GDP in U.S. dollars as a percentage of all emerging markets within the MSCI EM index and as a percentage of the global GDP. Share of EM market cap is for 2020 and is calculated as China’s market capitalization of listed domestic companies as a percentage of all emerging markets’ capitalization of listed domestic companies within the MSCI EM index and as a percentage of global market capitalization. *Currently, an index inclusion factor (IIF) of 20% is applied to China A Large Cap, ChiNext Large Cap and China A Mid Cap (including eligible ChiNext shares) within MSCI ACWI and MSCI EM Index. 100% A-share inclusion is shown for illustrative purposes only. Guide to China. Data are as of October 31, 2021.
2 Forecasts are not a reliable indicator of future performance.
3 American deposit receipts are shares of foreign companies listed on US stock exchange