Are policy funds staying true-to-label?

Asset Class in Focus

Riding China’s policy bus is not as easy as it sounds, as the poor performance of China policy-driven funds shows.

Are policy funds staying true-to-label?

China’s centrally-controlled economy gives investors opportunities to try and capitalise on the direction of government policies.

China announced key areas of policy emphasis in October 2017, for example, new technologies and upgrading of traditional industries; improving people’s well-being through education and healthcare; environmental protection/green development.

It would seem to be an easy matter to single out for assessment companies with business models tied to these areas.

The task is not easy, however, as the two Hong Kong-domiciled funds that explicitly aim to benefit from China’s policies have been among the worst performers in the China equity sector during the past three years.

The two funds are: the CCB International China Policy Driven Fund and the Shenyin Wanguo China Policy Focus Fund.

In the past three years, while the Hang Seng China Enterprises Index lost around 7% (measured from near the market peak in June 2015), the CCB International fund lost 42.5% and the Shenyin Wanguo fund lost 21.1%.

Both the CCB International and the Shenyin Wanguo products invest in Hong Kong-listed stocks, which limits their ability to target the whole range of mainland companies that are tied to growth in sectors the government is targeting for investment.

Style drift?

The CCB International fund factsheet says the fund can invest in companies that can benefit from the policies of China, a broad statement that could arguably apply to any company in the state-run economy.

The CCB International 2017 annual report does little to clarify the “policy driven” theme. The managers noted the growing southbound fund flows from China and the financial deleveraging campaign as drivers of their investments. The fund reduced positions in small-cap stocks and accumulated blue chips, as well as “mid-cap industry leaders that would benefit from China’s policies,” according to the report.

However, it is difficult to understand why the positions are distinct representations of companies driven by state policies. The top five holdings in the fund are puzzling: Tencent, AIA, HSBC, ICBC and HKEX, at the end of April accounted for 38.5% of the assets. The fund is highly concentrated, with around 20 positions and a high turnover.

Throughout 2018, the fund increased exposure to basic materials, insurance and property. In April, the fund continued to accumulate banks, pharmaceutical and home appliance stocks, while selling IT software, property and insurance stocks.

Despite the authorities’ emphasis on tackling environmental issues, no clear beneficiaries of such policies, whether companies or sectors, are apparent in the portfolio.

Luke Ng, senior VP of research at FE Advisory Asia, noted that the CCB International team conducted numerous shorter-term trading in order to deliver performance.  “That led to high volatility and tracking error versus Chinese equity market and peers,” he told FSA.

“The strategy didn’t work well in 2017 and it significantly underperformed the market, he said.” Moreover, the pivot from small caps to large caps was not timed correctly, further detracting from performance, he added.

The firm did not respond to a request for additional information in time for publication.

Ng noted that there are other China equity funds that use China policy as input to their investment decisions without explicitly stating so.

One of them is the Blackrock GF China Fund, managed by Helen Zhu, which “incorporates stock ideas that may benefit from structural reforms in China,” according to Morningstar. The fund, which also invests in offshore securities, but is much more diversified than the CCB International, has delivered a 11.4% return over the past three years.

China policy-driven funds

Note: fund returns in US dollars

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