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Total China: The future of investing in China

10 May 2019 | Markets and economy

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The Chinese economy has grown remarkably in the past decade. Even though the pace has slowed, China's growth rate is still very impressive. Recognising the significant role China plays in the global economy, global index providers have been moving toward a "total China" approach, by including more Chinese equity share classes into their emerging-markets indices. For example, beginning in June 2019, FTSE will be adding China A-shares to global equity indices, with a 25% inclusion factor.

As the second-largest economy behind the United States, and a growing contributor to the world marketplace, China is an integral part of any global investment portfolio. But investing in this fast-growing and dynamic market can be a difficult task, especially with the various Chinese share classes involved. Here, we examine the total China approach to investing, which attempts to create a well-balanced China equity portfolio by providing exposure to all Chinese share classes and market segments.

China’s equity market a critical diversifier

China is an emerging market and exhibits volatility in line with other emerging-market countries. But on a global scale, it has become the world's second-largest equity market, with an actively traded market capitalisation of US$ 11.5 trillion, just behind the United States. For investors, China’s equity market is just too big to ignore.

China is now the world's second-largest equity market

China is now the world's second-largest equity market

Note: "China" represents current equity outstanding for A-shares, H-shares, red chips, P-chips, S-chips and N-shares.
Source: Vanguard, based on data from Bloomberg as at December 2018.

China's equity market can offer diversification benefits in a global portfolio that many other countries cannot provide. While the US and European equity markets are highly correlated with the rest of the world (correlation coefficients of 0.97 and 0.96 respectively), China's equity market is much less correlated (correlation coefficient of just 0.69). The unique characteristics of the Chinese equity market make it a critical diversifier in a global portfolio.

In addition to the potential benefits of diversification, our research shows that Chinese equities have historically posted stronger gains after periods of relatively lower valuations. With a price/earnings ratio (P/E) of 14.8 times as at 31 March 2019, the FTSE Total China Connect Index was trading not far above its historical average (13.8) since 2008. According to Vanguard Capital Markets Model, we have projected an annualised return of 5-7% for onshore Chinese equities in the next 10 years.

Lower valuations have tended to precede higher return periods

China equity market historical P/E and performance1

Lower valuations have tended to precede higher return periods

Note:
1. The performance of “China equity market” is based on FTSE Total China Connect Index. Index performance is calculated based on monthly net total returns in RMB.
2. Based on the 25th-75th percentile of distribution of 10,000 Vanguard Capital Markets Model (VCMM) simulations for 10-year annalised nominal returns as of 30 September 2018 in RMB.
Source: Vanguard, using data from FTSE Russell and Bloomberg, as at 31 March 2019. Investment involves risk. Past performance is not indicative of future performance. For illustrative purpose only.

Why a total approach works

Within the Chinese equity market, there is a range of different share classes. A product that invests in a single share class, such as the onshore mainland China's A-shares or the offshore Hong Kong's red chips and H-shares, may not offer enough diversification. Even a product that invests in a combination of share classes may lack appropriate diversification. However, a total China approach, which enables investors to invest in all major Chinese share classes, can provide well-balanced exposure to Chinese equities, which could help minimise return cyclicality and improve an investor's return relative to the amount of risk they take on.

When looking at the relative returns of the various share classes in China's equity market, there has not been a consistent top performer over the past ten years. It may be tempting to try to pick winners and avoid losers but it is very difficult to do so in practice. For investors with a lack of conviction on which share class will outperform the others, a total China investing approach, with diversified exposure to all share classes, may be an appropriate fit.

The next 'winning' share class is hard to predict

The next 'winning' share class is hard to predict

Note: Relative performance of various Chinese share classes is based on total returns in USD of the respective index. Red chips represented by FTSE China Red Chip Large/Mid Cap Index; H-shares represented by FTSE China H Share Large/Mid Index; P-chips represented by FTSE China P Chip Large/Mid Cap Index; A-shares represented by FTSE China A Index; B-shares represented by FTSE China B Share Large/Mid Index; S-chips represented by FTSE China S Chip Large/Mid Cap Index; and N-shares represented by FTSE China N Share Large/Mid Cap Index.
Investment involves risk. Past performance is not indicative of future performance. For illustrative purpose only.
Source: Vanguard, using data from FTSE and Bloomberg.

In addition to diversifying across the multiple share classes in China, it is also important to diversify across industry sectors. Some Chinese equity indices are highly concentrated in financials, which can leave investors open to sector concentration risks. The lack of diversity across sectors, which can be a major issue in any market, is heightened in China, where there is a potential for volatility among certain sectors. A total China approach provides more balanced sector exposure, which can mitigate risk, while providing investors with an opportunity to take part in China's growth potential.

Balanced sector exposure to Chinese equities

Balanced sector exposure to Chinese equities

Note: Total China Index is represented by the FTSE Total China Connect Index.
Source: Vanguard, using data from FTSE Russell, as at 29 March 2019. Discrepancies due to rounding.

Diversification at home and abroad

The large Chinese equity market can provide a great opportunity to diversify a global portfolio. However, the significant variety of activities that make up China's economy, coupled with multiple equity share classes and quickly shifting rotations among market segment returns, can make it difficult to capture the market. A total China investing approach, which provides access to all share classes, can capitalise on the world's second-largest economy while also buffering against any possible slowdowns in a particular segment of the market.

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