China equities: the alpha opportunity

We are excited to actively participate in the China equity market as relative value investors. 

China equities: it’s now about alpha, not just beta

First of all I want to highlight that, after years of opening and reform, China is ready to offer alpha rather than just beta opportunities for global investors.

We define these alpha opportunities in three ways:

1. China’s deep involvement in the global supply chain: For us that means China is either quickly following or leading in innovation. So the dynamic between China and the rest of the world can help us generate many profitable ideas.
2. China’s entry into a ‘new normal’: This means accelerating industrial consolidation, where leading companies and their competitors will perform very differently.
3. QFII and RQFII reforms: these reforms will enable the A-share short borrow market to further develop, so the capacity of long-short equity strategies will significantly increase. As a result, we as relative value investors can benefit from information asymmetries, data science, and our understanding of industries in China to chase attractive risk-adjusted returns with low correlation to other asset classes and fund managers.

Investor positioning and market structure evolution are conducive to alpha generation

Currently, retail investors drive the market and hedge fund penetration is very, very low.

Value traded by investor type

Three ways to look at the China alpha opportunity

China is one of the markets that provides the best alpha generation opportunities for hedge funds, and we break it down in three ways:

1. China’s secular growth: from a top down perspective, China offers many secular themes to investors that offers opportunities for investors to identify both winners and losers.
2. A favorable market structure: looking from the bottom up, we think the market is under-researched and has high stock dispersion.
3. Attractive technicals: China’s markets are less crowded and have low foreign and hedge fund capital participation, which amounts to a fertile environment for alpha generation.

Inefficiency creates opportunities

The market is very inefficient, and the best way to illustrate this is to look at the coverage of companies across the different markets. 

For China A-shares, 70% of the companies in the market are covered by less than three analysts, that’s a significantly higher percentage than in other more developed markets.

Low coverage also means much higher dispersion, or higher volatility of the constituents of the market. Simply put, that’s the holy grail for alpha generation and allows you to find opportunities on both the long and the short side.

Turnover levels in China are off the charts compared to developed markets. 

That turnover is really driven by the large number of retail investors in the market, which provides hedge fund investors with good entry and exit points, as well as the ability to trade around that turnover.

Three myths demystified

We hear three kinds of myths about China hedge funds, let me demystify them in turn:

1. Isn't it a beta play? Our data tracking shows that China is a market for active investors. We’d go so far to say that active management in China's stock market is essential, especially in a down market and historically, hedge funds have even outperformed traditional active managers.
2. Can hedge funds actually produce high returns in China? Absolutely, with capital letters. Our data tracking shows strong returns, and with low volatility. Hedge fund investors care about the destination, but also care a lot more about the journey, and controlling that volatility is very important with good upside and downside capture.
3. Isn't one HF manager enough? We think it is not. We believe we can find low correlation between equity hedge fund managers is possible, and that there are opportunities for a different approach to hedge fund investing in the region.
   

Now we are seeing more institutional investors start to take notice and we have seen a significant increase in both interest and allocations from overseas into China and Asian markets.

Bin Shi (BS): Investors should stay invested. The A-share market has, overall, done very well and some of the sectors have done even better. 

If you look at the overall market, valuations are just above the 10 year historical average so from that perspective it is not so overheated. 

In the A-share market you are either hot or not. Some sectors are very hot, but other sectors did not participate as much. We believe we can still find long-term opportunities in those other not so hot sectors. So we are actively deploying our money into the A-share market at this point.

Jia Tan (JT): I would say it is more a process of learning by doing. 

When markets collapsed in 2016, regulators were against all kinds of short selling. As I mentioned, years of reform and opening have given them a chance to learn about how to build up healthy capital markets for China.

That’s the reason I stressed the importance of introducing biological diversity to the market. 

We wanted to celebrate when we saw the new QFII and RQFII rules last September because we think that is convincing evidence that the regulators are open to embrace the general rules of short selling used in developed markets. 

In the beginning, short selling activities are much less than those by long-only players, but give it some time and hopefully we can help to lower the volatility of the market, and then I think the regulators will feel more comfortable to let us do more.

Adolfo Oliete (AO): That’s a good question – they are certainly missing out!

There are two reasons. Firstly, let’s not forget that the hedge fund industry in China and Asia is still pretty nascent. If you look at the current AUM, it is still only roughly 10% of the US and a third of Europe.

We have seen a rapid increase in recent years, and that’s down to China. Before 2008, China equities accounted for about 6% of AUM in Asia, now it is over a quarter, so perhaps now there is a more diverse universe and people are more comfortable with it.

Secondly, though the returns and opportunity set are attractive, it is still not easy to allocate in the region for two reasons: dispersion is high both in the market and the hedge fund universe, and that dispersion grows when volatility increases – so you need to know how to pick; additionally, the market has nuances, like language barriers and stylistic differences.

But institutional investors are starting to realize that the unit of alpha that you extract per unit of risk can be far superior to any other market, so we expect to see more flows from this channel in the future.

BS: There has been some impact, but not too much. The Chinese A-share market is driven by domestic investors and domestic liquidity and global investors’ participation is, at this point, still comparatively small.

US moves to limit investment in some specific companies has had some impact, but that vacuum has been quickly filled by domestic investors.

With regard to ADR relisting in Hong Kong, I think they should continue to be listed in the US because they have benefited from the deep pools of money there and have also benefited US investors too since they have performed extremely well.

The size of the opportunity for Hong Kong depends on how they are treated in the US. If the US regulators can reconcile the difference in accounting standards, I think they (ADRs) will continue to be listed there and potentially seek a secondary listing in Hong Kong, which is fine.

This will benefit investors because at this point I own both ADRs and secondary listed Hong Kong names, and I like the fact I can choose between the liquid market in the US and Hong Kong listings, which trade in my timezone, which allows me to put ideas to work right away, instead of waiting for the US market to open. The ideal situation is to have a primary listing in the US and a secondary listing in Hong Kong and then let investors pick and choose whichever they prefer.

We will have to wait and see though. If Chinese companies are treated badly in the US and get unfair treatment, it is possible they will move their primary listing to Hong Kong, which has the potential to benefit local investors here tremendously.

AO: From a hedge fund perspective, US/China tension creates volatility and that’s good for us. As far as ADRs are concerned, we have seen a significant increase in companies coming back. If companies also continue to be listed in the US, that creates relative value opportunities for us. If they don’t remain in the US, it is good for the Hong Kong market because it makes it bigger and more relevant.

JT: Currently, we can only short stocks on the Stock Connect, so stocks that Northbound investors own. My best guess is that the size of the short borrow pool is around USD 10 billion, which covers all sectors but is mainly limited to large-cap names favored by the Northbound investors.

After the QFII/RQFII rules change, in theory our capacity will increase and we can do short selling on the STAR board. On the main board and Chinex board we can actually use the stocks owned by the prop desk of the domestic China brokers and also reach out to domestic and mutual funds. In the future, maybe other QFII investors, like insurance companies and pension funds, will be able to lend out their stocks to us.

AO: When we talk about China long/short space, it’s not just A-shares. Currently you can have a long/short strategy where A-shares is still very nascent and still run a long/short strategy using shorting capacity in Hong Kong and the US. However, when A-shares come on board, I think it will be the holy grail for hedge funds in the region.

BS: Definitely yes. You can’t just focus on isolated incidents like Ant Financial. A-shares are still not perfect, but neither are other markets. I believe the A-share market is still a good market in which to make money and generate a return.

On antitrust legislation, actually it was announced many years ago. What we are seeing now is stronger enforcement, which may have surprised people. The reason behind it is that the internet platform companies are becoming very large indeed and their strategies can have major impacts on the whole country. As such, I believe there is a need for stronger enforcement of antitrust regulations.

AO: But let’s not forget that antitrust rules are not just China specific, we have seen them in the US and may see an acceleration with the Biden administration. Ultimately the tech wallet is not going away, it just may be distributed to other companies which, again, provides opportunities for new winners to emerge.

AO: Yes. The equity long/short side still dominates the Asian hedge fund industry, certainly from a scalability and from availability of different players and talent. However, from a relative value perspective, QFII significantly changes the opportunity set significantly.

Credit is not as well developed as other markets, but we are starting to see more players and opportunities as the repo market evolves, so you can short a bond and have a proper long/short construct. Fixed income is still not developed enough.

TJ: I’ll highlight two key words: policy and science.

On the policy side, a few policies have been gamechangers for the whole sector. For example, the National Reimbursement List Negotiation and Group Procurement policies have changed the fundamentals a lot.

If we look at the competitive dynamics between the novel drugs and the generic ones, international medical devices and domestic replacements, and the companies focusing on R&D and those focusing on sales and marketing, the long-term outlook will be very different and we believe we can find a lot of structural opportunities.

Looking at the science, many domestic companies have been ‘fast-followers’ of big global pharma companies and some of them have licensed out their molecules to the MNCs and even tried to develop ‘first-in-class’ drugs globally.

Just recently, a Chinese biotech company signed a deal with a global pharma company in which it would receive a USD 650 million front payment and up to a USD 1.3 billion as a milestone payment.

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