In Case You Weren’t Keeping Score—Onshore China Stocks Won in 2021
Phillip Wool, Ph.D.
Head of Investment Solutions
Our focus at Rayliant is bottom-up quantamental selection of Chinese stocks—the kind that takes advantage of amateur investors’ mispricing of hundreds of individual companies to earn its alpha. We expect our strategies to steadily harvest behavioral alpha, not expose our clients to huge volatility from bold market timing calls for the benefit of an occasional windfall. That said, there is one piece of asset allocation advice we’ve been giving over and over again since Rayliant launched: The onshore China A shares are a better place to be than the ADRs and Hong Kong listings trading offshore.
As 2021 draws to a close, we’re inclined to record that ‘bet’ as a winner…
It’s obvious from the chart that mainland-listed A shares have been the best performers in a tough year for Chinese stocks. To the investment team at Rayliant, this wasn’t a big surprise.
The Argument for Onshore China Exposure
From Day One, our focus has been China’s onshore stocks, the A shares. It’s something we started pounding the table about as early as 2018. We’ve always believed that’s where the growth is going to be, whether you’re looking at global equities, emerging market stocks, or even comparing onshore and offshore Chinese shares. It’s also where investors have historically seen the most opportunity to diversify. And with amateur retail traders accounting for over 80% of volume, it’s the largest reservoir of behavioral alpha for active strategies to exploit. These are points we’ve been making in webinars, to our friends on LinkedIn, and even in our journal publications.
We’ve been repeating this message because we think it’s an important one for our clients to hear. More investors are seeing the opportunity China presents, recognizing it’s too big a market to ignore, but then feeling the ‘paradox of choice’ when it comes to how they access it. Too often this leads to either (1) allocating to a global EM fund, hoping it provides good China exposure, when all they’re really getting is offshore China, or (2) investing in thematic China growth strategies, which turn out to be even worse, loading up on the most expensive Chinese stocks, all of which are listed offshore. As the chart shows in no uncertain terms, these have both been unfortunate choices in 2021, precisely because they’ve missed out on the A shares.
Between the tech crackdown and escalating tension with the US, offshore China has been beaten up in 2021. Some stocks have probably been oversold, and we wouldn’t rule out a moderate bounce, more regulatory and geopolitical pain, or a little bit of both for Chinese ADRs by the end of 2022. That said, nothing about the last year has changed our thesis since we started reporting on the relative benefits of onshore China.
The Argument for Active Management in China
In addition to making the case for onshore China exposure that much stronger, events unfolding in China over the last year—from tech regulation to power shortages to Common Prosperity—have strengthened the other case we’ve been making since we started: Investors should favor active strategies over a passive approach in markets like China’s, full of unique risks and retail investor bias that creates behavioral alpha.
Indeed, the very conditions that prompted anxiety on the part of those tracking Chinese equities throughout 2021 created opportunity for active strategies like Rayliant’s. For example, although exposure of onshore stocks to the tech crackdown was relatively low, fear-based selling inevitably spilled into China’s mainland market, resulting in attractive valuations for A shares in the IT sector, including bargains in some domestic chip makers who will actually benefit from state support as policymakers push semiconductor self-sufficiency in the nation’s ongoing technological competition with the United States. Likewise, the energy shock experienced in the latter half of Q3—driven in part by China’s effort to hit ambitious carbon emission targets and skyrocketing coal prices—ultimately highlights the risks of reliance on coal power and the importance of renewables and more efficient energy utilization. Such recognition is likely to spur further growth in the nation’s new energy sector, an area in which Chinese firms are already taking an increasing lead. It’s catalysts like these that drove active outperformance in China throughout 2021 and continue to make it a prime target for alpha-oriented managers.
Reevaluating China and Emerging Markets
Given the strong case to be made for onshore China exposure and active strategies in emerging markets, we urge investors reevaluating their EM and China allocations at the turn of the year to consider dedicated active exposure to onshore stocks, like that we’ve constructed in the Rayliant Quantamental China Equity ETF (RAYC).
As mentioned, our edge is not making bold market timing calls. Nevertheless, we’ll close with one final statistic that highlights the present importance of this conversation. As of December 17th, with the Fed talking about tapering, the P/E of S&P 500 stocks stood at 25x, while onshore Chinese stocks in the CSI 300 Index were trading at just under 18x. Predicting where global stocks will be in another twelve months isn’t easy, but when high growth and low prices coincide, as they do for onshore Chinese stocks, it’s usually not a bad thing for investors.
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