News of a massive economic stimulus package in China transformed the fortunes of many emerging market (EM) investors in September. After the announcement, the MSCI China Index comprising onshore and offshore Chinese equities jumped by 32% through Sept 24 to Oct 7. Since then, it has retreated by 16% as of Dec 4.
However, not all Chinese equities fared equally well during the market jump. And while some market participants expected improved outlook for the economy after the stimulus, how international investors are positioned in China can make a big difference to their overall portfolio performance.
MSCI’s analysis of the factors behind China’s breathtaking rally by researchers Zhen Wei and Cheng Lyu revealed that outperformance initially came from high-volatility stocks (those typically experiencing larger price swings) and from more-liquid stocks (those that are more actively traded and easily bought or sold without significantly affecting their price). In contrast, the short-term performance of some factors, especially momentum, was negative.
Historically, factor behaviours in China’s onshore and offshore markets have exhibited different trends, but with the stimulus, initial outperformance turned prominent in both markets for higher-volatility and more-liquid stocks.
With the biggest weighting in the MSCI EM Index, understanding Chinese equities is essential for EM investors. So what lessons does this analysis hold for EM investors? To answer that, we need to look beyond the frenetic trading days around the end of September and consider the drivers of outperformance over a longer period.
The China X factor
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China's equity markets have three distinct segments. The onshore A-share market, listed on the Shanghai, Shenzhen and Beijing exchanges, primarily serves domestic investors. The Hong Kong market includes Chinese companies listed in Hong Kong, providing greater international access but higher volatility due to global market influences. Then there is the overseas market, which includes Chinese companies with equity listings on international exchanges, like the NYSE.
Each market differs in liquidity, risk profile and regulatory environment, presenting diverse investment cases.
After outpacing other EM indexes in 2019 and 2020, Chinese equities lost ground amid macroeconomic and geopolitical uncertainty. Even in a down market, however, the top-performing funds still delivered annualised excess returns of 10% over the three-year period from 2021 to 2023.
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To find out more, MSCI analysed two groups of top performers: China funds that invest in both offshore and onshore Chinese equities, and those that primarily invest in A-shares.
In China funds, style factors, including high exposure to dividend yield and value factors in the offshore market, as well as low exposure to beta, growth and large-cap stocks, helped mitigate volatility and drive excess returns. In contrast, return drivers in top China A-share funds were mainly specific equities returns with supportive contributions from style and market factors.
To help investors better understand return drivers in dedicated China allocations, MSCI has introduced a three-layer framework, encompassing top-down and bottom-up market drivers, and ecosystem components.
- Top-Down: Macroeconomic policy, market accessibility, segmentation and the distinct roles of state-owned enterprises (SOEs) versus non-SOEs shape market dynamics and can inform portfolio strategies.
- Ecosystem Components: Regulator interventions and the broader ecosystem of financial products in China, including the development of ETFs, influence market dynamics. Recognising their influence can help uncover further return drivers.
- Bottom-Up: Different investor classes and interests in megatrends, like energy transition or transformative technologies, offer insights into market behaviour and asset allocation opportunities.
This framework can help explain why some segments of China’s equity market outperform – and why an investment that tracks the broadest benchmark may not always be the best option.
Looking beyond market beta
Examining factors that have historically led to higher returns – like value, quality or momentum – help translate data points into actionable insights.
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For investors looking for a deeper understanding of these drivers across the EM universe, MSCI’s EM Equity Factor Model provides additional insights and risk management tools. China’s influence is taken into account with ex-China and All-China options.
Wider benefits for active or passive asset managers and owners include:
- Enhanced risk assessment: Breaking complex portfolios down into intuitive risk factors can provide a structured understanding of exposures.
- Crowd thinning: The model allows investors to identify clusters of highly similar companies and evaluate the ‘bubbliness’ of a strategy to mitigate crowding risks.
- Adaptability: Relationships between investment factors can be adjusted based on current market conditions and over multiple cycles. A machine learning component also assists in capturing non-linear relationships between factors to enhance performance during times of uncertainty.
- Sustainability: The model can help measure exposures to ESG factors and assess carbon intensity, enabling investors to align with sustainability goals or to meet decarbonisation objectives.
- Diverse structures: New factors, such as earnings variability and investment quality, provide a more comprehensive toolkit for portfolio construction. A State Ownership factor has also been added to the China factor structure.
The rally in Chinese equities at the end of September underlined the ability of EM investments to deliver uncorrelated, diversified returns. In the dynamic world of EM investing, MSCI is committed to developing tools to help investors refine their strategies, capture the benefits of diversification and sharpen their understandings of excess return drivers in China and the EM universe beyond.
To find out more about investing in China, please visit MSCI's webpage.
