Entering the golden age for China long/short investing

China now represents 19% of global GDP¹, and its economy cannot be underestimated.

We believe that China’s markets are becoming a key source of alpha and China’s transition from beta to alpha is one of our current ‘mega-trends’ in relative value investing.

We break alpha down into three components.

Firstly, ‘investment acumen alpha’ from the skill of the portfolio manager vs. peers; secondly, ‘cyclical alpha’ which we attribute to market dislocations from policy errors or external events; and thirdly, ‘structural alpha’ which we define as regulatory impediments or improvements that create opportunities that are long-term and structural in nature.

We view China as a major opportunity for structural alpha.

Historically, relative value investing in China was limited to exposure to dual listed companies, or single names in the A-share market hedged with indices or ETF products, with much of performance driven by beta from directional positions rather than alpha.

Today China is actively focused on reforming its financial sector, and we believe that is creating opportunities for relative value trading that hasn’t been available to investors in the past. 

Historically China’s A-share markets have had relatively few hedge fund participants relative to markets of similar size, and many hedge funds trade broader Asia strategies, e.g., Japan and Hong Kong, as opposed to specific China A-share focus. 

Until recently it was difficult for hedge funds to transact in underlying A-shares aside from simple long positions, so there are relatively few participants actively hedging and shorting in specific securities.

Additionally, the China A-share market is dominated by retail investors with approximately 165m registered individual investor accounts², and we estimate approximately 55m of these actively trade every day.

The dominance of retail investors creates dramatic swings in momentum and valuation skews which can present unique alpha opportunities for relative value investors on both the long and short side of portfolios.

Onshore market turnover is large – and increasing One goal of the recent reforms is to increase turnover on China’s exchanges – an important metric that should allow Chinese markets to attract flow from institutional investors.

Over the past few quarters we’ve seen a steady increase in turnover in China, to the extent that it already exceeds turnover levels in both the rest of the Asia-Pacific region and Europe.

This turnover has been driven by the large number of retail investors in the market, which provides hedge fund investors with volatility and dispersion, which may result in good entry and exit points, as well as the ability to trade around that turnover.

There’s not a lot of analyst coverage of the China A-share market, particularly of mid/small cap companies, and according to Reuters almost 70% of companies are covered by three analysts or less.

Additionally, only about 300 to 400 companies have English language research coverage, a small percentage of the overall market -  which means the visible opportunity set for global investors remains small.

So, taken together, we believe these four factors  - high retail participation, improving liquidity, reforms to allow shorting and margining, and low analyst coverage - combine to create a “golden age”  for relative value investors like O’Connor. 

We believe that these dynamics will be prevalent over the long term; we foresee very little substantive change to them in the next three-to-five years.

A good example is retail dominance in the market: while the influence of institutional investment capital is growing, it will likely take years for it to overtake retail investors as a key driver of the market. We believe that there is a compelling  window of opportunity to exploit this imbalance over the longer term.

Both O’Connor and the larger UBS have had a longstanding presence in China and our ‘boots-on-the-ground’  makes a huge difference to our ability to generate alpha.

Looking back on when long/short funds opened in Japan, we saw many portfolio managers stay based in London or New York. We felt those managers were at a disadvantage - particularly when understanding the small- and mid-cap side of the market - because they lacked real relationships with management teams and industry leaders in the local markets. 

O’Connor is establishing a team on the ground in Shanghai that should capture valuable insights into the local markets, and  UBS Asset Management has a separate large, established presence and network in China that we can leverage to support our relative value strategy.

Our China L/S strategy invests long and short across the China A-share market and offshore-listed Chinese companies, focusing on sectors where we see the most opportunity. Currently these sectors are financial services, health care, consumer, and TMT – and we plan to expand coverage to other areas as opportunities unfold.

We believe the current market evolution in China is one of the best investment opportunities we have seen in many years and we’d go so far as to say that it will provide a “golden age” for relative value investors.

We believe that thanks to the to the recent QFII and RQFII reforms hedge funds can more effectively capture long and short alpha and dynamically manage beta, sector, factor, thematic, and idiosyncratic risk in China.

Our approach offers a highly differentiated approach to existing China long-only strategies which we believe will be compelling in a market currently lacking long/short equity investment options.

Our global expertise coupled with our deeply experienced local investment team, offers what we believe to be a  strong competitive edge to capture  one of the best relative value alpha opportunities in the world today.

¹ International Monetary Fund, December 2020
² UBS, July 2020