Chinese share classes: Getting past the letter A
Over the past two decades China has been steadily increased foreign access to its domestic A and B Share markets. This process started in 2002 with the Qualified Foreign Institutional Investor (QFII) program – greatly expanded in 2012 – and was followed by the Hong Kong-Shanghai and Hong Kong-Shenzhen connect program for qualified investors in 2014 and 2016.
With liquidity and transparency improving in China’s domestic market, global indices are increasing the share of those indexes allocated to Chinese A Shares. As a result, the narrative about Chinese equity over the past two years has been dominated by this single share class.
For most foreign domiciled mutual funds, however, Chinese A shares only make up a portion of their portfolios, with the remainder allocated between eight other Chinese share classes – H Shares, B Shares, Red Chips, ADRs, P Chips, S Chips, N Shares and T Chips.
EPFR’s new China Share Class Allocations dataset, released in April, provides investors and financial professionals with quantifiable insight into the multiple share classes that make up most funds’ allocation to China. It also opens the door to new quantitative analysis and modelling of China’s equity market.
Profiting from the A share squeeze
One area EPFR’s quantitative research team has been focusing on is the impact of, and opportunities created by, the growing A Shares footprint.
As the chart below illustrates, allocation to domestic China stocks (A Share + B Share) have been on the rise since August 2018. Meanwhile, the average allocation to oversea listed companies (ADR + N Share + S Chip) have remained relatively stable while the biggest drop in funds’ exposure to Hong Kong listed stocks (H Share + Red Chip + P Chip) occurred between 2015 to 2017.
Chart 1 – Simple Weighted Average Allocation to China Share Class
That overall exposure to H Shares has remained steady since 2018 despite the official and market focus on A Shares raises several questions. One simple one is this: If A Shares are, will or should be favored by investors, why aren’t allocations to Hong Kong listed stocks decreasing?
Addressing that question, as it turns out, has the potential to unlock excess returns.
Converging in a contrarian sort of way
Chart 2 below shows that passive managers are rotating exposure from Hong Kong listed stocks to A Shares in order to remain in step with their benchmarks. But the impact on that of the average allocation for all funds is blunted by the decision of active managers to remain invested in HK listings at the current 10-12% level.
Chart 2 – Simple Weighted Average Allocation to Hong Kong listed stocks (Active vs Passive)
One implication of this is the narrowing of Active Investor Spread (AIS), representing the difference between active and passive fund allocations to Hong Kong listed share classes. Overall, the gap between them is closing steadily (see Chart 3 below).
Chart 3 – AIS (Active Investor Spread)
If we overlay the month-over-month AIS change and the benchmark’s performance, it suggests that the AIS change is a reversal signal.
Chart 4 – Month-over-Month AIS VS Benchmark
If this is true, there is value in shorting the asset – in this case H Shares -- if the AIS widens and going long if the spread narrows.
So far so good
To test the theory in a more systematic way we applied a simple approach. If the AIS indicator at time T is higher than time T-1, we short the asset at time T+1 and if the indicator at time T is lower than time T-1 we go long the asset at time T+1.
A naïve back test of this strategy, illustrated in Chart 5 below, shows the potential value that even a very simple approach can unlock from the new data set.
Chart 5 – Indicator VS Benchmark Performance
In future Quant’s Corners we will discuss refinements to this approach and new ways to utilize the China Share Class Allocations data set.
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