Seeking calm through China’s wild swings

After a pummeling in 2018, China shares have started the year vigorously. The MSCI China Index is up 7.47% to 30 January, outstripping the MSCI AC World by half a percentage point.

Of course, anyone with an investment horizon longer than a day trader and with a memory more disciplined than an inveterate gambler knows that a month of positive returns does not herald a period of sustained performance.

If tempted to abandon caution, reflect that the MSCI China index plunged 31.13% last year, compared with a 9% decline by the MSCI AC World index.

Moreover, although it has made a five-year cumulative return of 48.81% compared with 40.2% by the MSCI AC World, it is at the expense of much higher annualised volatility – 20.61% versus 12.15%.

Most notoriously, the Chinese stock market crisis from June 2015 until February 2016 saw a third of the value of A-shares listed on the Shanghai Stock Exchange lost within a month. Further steep declines followed, despite the efforts of China’s regulators to shore up prices during the summer. A brief rally in December preceded another sharp sell-off in January 2016 that led to a trading halt.

The pull of valuations

Yet, there are compelling reasons now for raising allocations to China, according to several asset managers.

“China’s A-shares are at crisis-level valuations for an economy that is still growing faster than most places around the world. Indiscriminate stock selling by local investors on the back of trade tensions with the US have left China’s A-share market trading at less than ten times earnings compared to 16 times a year ago,” wrote Eric Moffett, Portfolio Manager for T Rowe Price’s Asia Opportunities equity strategy earlier this week.

Tim Orchard, chief investment officer for equities in Asia-Pacific ex-Japan at Fidelity, pressed the valuation case at the start of the year.

“Valuations are now very supportive…The selloff that was witnessed in 2018 has provided a myriad of opportunities in China for the active stock picker,” he wrote.

Pictet Asset Management picked China as its “favourite market…which offers the best value among its peers at a 12-month price/earnings of 10 times [compared with a historical average of 12 times].”

Mandy Chan, investment director and head of China and Hong Kong equities at HSBC Global Asset Management, agreed that “current valuations are undemanding after the sharp correction”.

Underlying this widespread optimism is a confidence that China’s policy makers will continue to introduce fiscal and monetary measures to mitigate slowing economic growth.

Chronic volatility

But, there is also a general recognition of potentially destructive headwinds, such as higher commodity prices, a stronger dollar, increased trade tensions and further declining GDP growth despite the Chinese authorities’ best efforts.

In this fragile environment, China A-shares seem likely to experience the volatility that investors have become accustomed.

Fortunately, there are funds that have managed to achieve strong cumulative returns, while enjoying less volatility than the index and their peers.

The Matthews China Dividend Fund stands out for its 58.85% five-year cumulative return with annual volatility of 14.93%, and the Invesco China Focus Equity Fund is also impressive (49.63% and 16.45% respectively).

Both funds are quite conservatively run, with core holdings in major telecom and technology stocks. FE Analytics has awarded the Matthews fund five crowns and its con-manager Yu Zhang an alpha manager rating.

The most volatile funds tend to have significant exposure to financials and “old economy” heavy industry stocks that dominate local indices – which make them more vulnerable to local retail-led market gyrations.

Returns vs volatility of China Equity Funds 

Source: FE Analytics (US dollars)

China Equity Funds Sector Average vs MSCI China Index

Source: FE Analytics (five-year cumulative performance in US dollars)