John Bradshaw Jia Tan (TJ)

Given this year’s positive market sentiment on China, investors are asking whether there is still merit in a long/short strategy with a low net approach. UBS O’Connor Investment Specialist Mariana Paul sat down with John Bradshaw, Head of Asia Long/Short, and Jia Tan (TJ), Head of Research, China Equity Long/Short, to talk about how such a strategy could capture a differentiated source of returns through its alpha generation. The approach could complement a beta-driven strategy and improve risk-adjusted returns across different market cycles. Highlights of the discussion follow.

In our view, an alpha-driven, relative value investment approach still stands for China today

  • We believe that there is a long runway for structural alpha opportunities in China on the back of both the market and macro developments that are supportive of its economic growth.
  • While growth this year will more than likely be stronger than last year, the uncertainties around the strength of recovery and the policies create ample cyclical opportunities to generate alpha in our view.
  • Because of the country’s decade long, strong secular growth, a long-bias approach is often the default for many investors when it comes to China. However, in recent years, this approach has proven challenging in generating competitive risk-adjusted returns.
  • Focusing on alpha opportunities and not just beta, our approach seeks to be agnostic to market directions and looks to exploit inefficiencies in the onshore China A-share market due to factors such as high retail participation, high turnover, low institutional penetration and low sell side analyst coverage.

Short-term and long-term risks in the current upward market

  • Although the Chinese government is prioritizing economic growth this year, we believe that a robust recovery is not a foregone conclusion as the recent stock rally may have suggested, and without more aggressive policies, a weaker-than-expected recovery could be the outcome based on our independent, on-the-ground research.
  • That could suggest the beta driven market since last November may be coming to an end and an alpha-focused strategy will perform again.
  • Short-term risks, especially prior to the Two Sessions in March, include: i) China-US geopolitical tensions and related trade sanctions, ii) seasonality, iii) uncertainties in the scale of the government stimulus, and iv) recession risk in developed markets.
  • Long-term risks markets may have overlooked include: i) waning wealth effect from property market, ii) lower expectation of steadily growing disposable income post pandemic, iii) aging and shrinking population, and iv) prioritization of labor versus capital in process of resource allocation.

What worked and what didn’t work in 2022

  • At the start of 2022, a more defensive positioning partly from our early exit from property market exposure helped manage downside risk. A lower leverage ratio, a proactive buildup in structural alpha short positions and reduction of index shorts also helped.
  • Our long investments in healthcare, automobiles, property management and developers as well as our short positions in technology and consumer sectors proved advantageous.
  • Following the policy announcements after the National Party Congress in November, extreme moves driven by sentiment and the high volume of global fund flow back into China took us by surprise. The beta driven rally hurt our performance, even though it is by nature challenging to low net, long/short strategies with a focus on fundamentals.
  • We adapted and rebalanced the portfolio that helped to capture the beta rally without compromising the downside risk.

Exploring new investment ideas

  • We see opportunities in advanced manufacturing industries including electric vehicles, solar power, robotics, automation and semiconductor equipment.
  • There is exciting potential tied to decarbonization in green power, materials and commodities.
  • We are looking at companies that can cater to the ever-changing consumer preferences of the different generations.
  • The technology self-reliance theme could translate into opportunities in hardware, artificial intelligence and other cutting edge technology.

Our low net approach as a differentiator

  • Our long/short strategy was built to be all weather, performing well through the 2020 bull market and the 2021-2022 bear market.
  • Our strategy was never structured to outperform or replace long-only strategies in a bull market. Instead we believe that it could make a good complement and diversifier to a more beta-dependent approach and could be able to generate competitive risk-adjusted returns in a market driven by fundamentals.
  • Our past success was not attributed to a play on directionality or the beta of the market. Factors instead include: i) select leverage to maximize upside capture, ii) strong stock picking on both long and short sides, and iii) profitable short positions.
  • A long/short strategy with a relative value approach to investing may bring different, uncorrelated sources of returns.

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