US investors are arguably under-invested in Chinese equities and should change to diversify. But China's regulatory landscape and corporate governance - or the lack of it - are big concerns. Trade tensions, such as over Beijing's treatment of Western intellectual property, remain. This article delves into what investors should do.

Investors need to be more aggressive when considering Chinese equities, say investment executives, while not ignoring the abundance of corresponding risks.

“In our experience clients are under-allocating to China relative to the size of the opportunity,” Alejo Czerwonko, chief investment officer, emerging markets Americas, for UBS, said. However, he added, “there are no shortage of long-term risks.”

Nonetheless, China’s “extraordinary” economic transformation simply can’t be ignored, Czerwonko maintained. China’s equity markets capitalization has increased by around 25 per cent in the past 20 years and now makes up about 11 per cent of total global market capitalization, he noted.

Now the second largest economy in the world, China accounts for about 20 per cent of the world’s economic output and close to one-third of annual global GDP growth.

A recently-published UBS report Investing in China: Opportunities for global investors notes that China, whose population of 1.4 billion is four times larger than the US, is spending twice as much on research and development than the US, has twice as many supercomputers and nearly 500,000 more industrial robots.

What’s more, China accounts for 57 per cent of the global e-commerce market and is expected to soon introduce a digital currency, leading a transformation to a cashless economy. Also, the renminbi is now the eighth most traded currency in the world and is poised to become a key international reserve currency.
 

Advantages
China’s success in controlling the spread of the coronavirus, allowing economic growth to normalize more rapidly than in the US and Europe, has also made it an attractive investment option.

“China is a great place to be post-COVID,” said Brad McMillan, chief investment officer for Commonwealth Financial Network. “The caveat, however, is that those [equity market] gains may have already been made.”

Diversification is another benefit of having portfolio exposure to China, according to investment officers.

“China tends to zig when the US and Europe zags,” said Mark Hackett, chief of investment research for Nationwide Funds chief of investment research.  “It’s a natural hedge in a portfolio and diversifies emerging market exposure. Investors tend to forget that China is a major commodity user and not just an exporter.”

“Diversification is very real and incredibly valuable,” said McMillan. “The US and Chinese economies are in many ways decoupled and the world may be increasingly divided into separate spheres where one or the other dominates.”

Getting in
The safest way for US investors to participate in Chinese equity growth is through an established mutual fund, investment professionals agreed.

“Unless you have better information than a professional investor, the average person is better off investing in a fund,” McMillan said.

TAG Associates favor low net exposure Chinese and Asian hedged equity funds said Jeffrey Tumolo, chief investment strategist for the wealth manager.

“We think there are great opportunities in absolute return and relative value strategies in China,” Tumulo said. “Recent disruptive events and general Chinese market volatility have likely increased return potential in arbitrage-related investments and in long/short equity strategies.”

Investors can also buy shares of Chinese companies as ADRs on the New York Stock Exchange (where there are currently 149 Chinese ADRs with a market capitalization of close to $2 trillion). 

Nearly 300 mainland companies trade on the Hong Kong exchange as so-called “H-shares.” Companies traded on the Shanghai and Shenzen stock exchanges are referred to as “A-shares” and sell stock to retail investors through the Northbound Stock Connect Program.
 

Caveats
What are the primary risks for investors?

China’s regulatory landscape and corporate governance - or lack thereof - are major concerns.

As the UBS report diplomatically puts it, assigning probabilities to these risks is difficult because they “hinge to great deal on political calculations, which are less predictable than economic factors.”

A business executive who has lived in China for more than 20 years, and asked not to be identified for fear of reprisal, was blunt: “I have always stayed away from China equities simply because they need to be monitored on a daily basis.”

“All is good and relatively straightforward until the government decides it is not,” the businessman continued. “Just look at what’s happening to Jack Ma (co-founder of e-commerce giant Alibaba and controlling shareholder of fintech sister company Ant Group).”

An even bigger risk than government interference is “a general lack of accounting principles” and opaque corporate structures, he added. 

“You are never 100 per cent sure of what you are buying or who controls what,” the businessman explained. “Investors in Chinese companies who have made money have done so because they have boots on the ground. They understand the local mindset, and monitor the businesses they invest in to the extent that they can pull their money out almost immediately if they smell something not kosher.”

Cause for concern
Volatility and high valuations are also concerns.

“Chinese stocks are expensive,” Hackett said. “And there’s a lot of liquidity and borrowing on the margin.”

Valuations are “stretched in aggregate,” according to Tumolo. “There will likely be a hangover to COVID stimulus that may or may not be offset by the increased global economic activity resulting from reopening. We are not allocating aggressively in directionally long investment strategies.”

Investment professionals also worry about China’s aging demographics (“the country may get old before it gets rich”), its ability to continue dominating global exports and its high levels of debt. 

“Debt is a pre-pandemic problem,” Czerwonko said. “Whether there is a smooth de-levering or a possibility of things getting out of hand is a cause of concern.”

Superpower showdown
But clearly one of the darkest clouds hanging over any investment in China is heightened political tension between the US and China.

China’s relationship with the US “has become strained and at times outright hostile,” the UBS report stated. “US investors face the risk of new US regulations constraining their access to China’s markets.”

“The two biggest economies in the world are facing off in a secular power struggle,” Czerwonko said. “We don’t know what the future will bring.”

Perhaps the most realistic - and sobering - assessment of the situation came from US Secretary of State Anthony Blinken after meeting with his Chinese counterparts earlier this month in Alaska: “Our relationship with China will be competitive when it should be, collaborative when it can be, and adversarial when it must be.”