China Large Caps Attractive After Sell-off

The correction in the Chinese stock market has thus far been nothing short of impressive. The slide on Monday was the worst in eight years, and a growing number of well-known investors are looking for the exits.

But Curtis Tai, vice president and ETF specialist at CSOP Asset Management, has a more measured view of the opportunity and the risk involved with investing in China today.

Tai, whose firm is the world’s largest renminbi qualified foreign institutional investor, with a $7.5 billion quota, and a newly minted ETF sponsor following the launch of the CSOP FTSE China A50 (AFTY), says there may be storms on the horizon, but picking within segments, and from different share types, holds the key to getting the best results out of an emerging market in transition.

The chart below shows the performance differences between ETFs that invest in A-Shares, Hong-Kong-listed stocks and AFTY.

Chart courtesy of StockCharts.com

ETF.com: We saw more than $2 billion in assets flowing into China ETFs in the first half of this year. The market rallied hard up until June before a big correction began. How do you characterize the market action we've seen this year?

Curtis Tai: On the surface, it was definitely a speculative run. It’s a momentum-driven market. But if you delve deeper, the rally was really caused by a reallocation of assets.

The majority of the equity market right now is being dominated by retail investors—they make up about 80 percent of the market, while institutions make up about 20 percent. In Hong Kong, for instance, it’s around 30 percent retail/70 percent institutions. And in the U.S., for comparison, it's around 9 percent retail/91 percent institutions.

That’s important, because in China, retail investors are not as educated about financial investments as institutions or professionals. But they do understand opportunity costs and risk versus return.

The reallocation of assets took place because retail investors only have three real options for investing. The first is equity markets; the second is properties markets; and the third is wealth management products—vehicles that return a set amount of yield, such as money market funds.

Investors had previously gone big into real estate. Up until 2014, the properties market had a huge run-up and there was a lot of construction. Now there's overstock of inventory and not a lot of real demand for housing. So we’ve seen a correction in the properties market.

Wealth management products, on the other hand, used to be very popular in the past five years, but yields have come down dramatically.

Thus, investors turned to equities. It started in the middle of 2014 as Stock Connect opened up and foreign investors started to come in. Now we’re seeing a marketwide sell-off where the market started to decrease, margin calls were hit, and retails were being forced to sell off their position more and more to meet the margin calls.

That basically caused a snowball effect. Even as the Shanghai Composite faces a correction of around 30 percent, it's only about a third of the total run-up. This market correction was somewhat expected.

ETF.com: Are 30 percent of shares still not trading after the government stepped in?

Tai: Yes. About 500 stocks right now are still suspended out of 2700-plus, accounting for 13 percent of the total market cap. They are mostly mid- and small-caps that are halted. There were 1,200 stocks suspended at the height.

ETF.com: Do you think the Chinese government’s intervention to prop up stock prices and limit selling has fundamentally broken the way the market is supposed to work?

Tai: The Chinese government wants stability in the economy and stability across the markets. Now the problem is that when you have such a large retail-driven market, and everybody floods one way, the government can do very little to cool off a market.

They can stabilize the market by providing support, but volatility is a huge issue because the market isn’t as driven by professional, institutional investors, but by retail.

ETF.com: For a U.S. investor, is market accessibility still a problem in China? Is that a concern?

Tai: I would say the concern for Asian investors, and other emerging market investors—compared with U.S. and Europe investor—is different. In the U.S., I would absolutely say investors are worried about accessibility.

But in Asia-Pacific, they're a little bit more accepting, perhaps because they're an emerging market themselves. They understand that the movement from a momentum-driven market to a more fundamentals-driven market is a growing pain that occurs in all markets, going from frontier to emerging to developed.

ETF.com: Opinions are very divided on the opportunities in China today. People like Ray Dalio say China's market crash was the canary in the coal mine for more weakness ahead. Others see great long-term potential in China, but mired with volatility—are you in that camp?

Tai: You nailed it. In the short term, there will be volatility, but remember, there'll be opportunities in the short term, as with high volatility, you can have higher returns. But we're still looking at it from a long-term view. And the long-term direction is stability.

Look at its track record. During the properties rally run-up, everybody complained that properties prices were too high. So they implemented measures to cool off the properties market, and it corrected. When that correction first started, everybody was worried about China having a hard landing. But that didn't happen. We’re now seeing a pickup in housing sales.

Same with shadow banking. Everybody was worried about the size of the shadow banking system, and its depth. Now shadow banking growth has slowed down, and a lot of new debt is being made very transparent.

The last thing is the equities market. China has been trying to open up its capital markets; it wants to stabilize this as a long-term growth and investment opportunity. So far, they've been more or less successful.

If you look at the actual monetary effect of the correction, it's not that much. The main source of wealth accumulation for retail investors is income—wages. A breakdown of asset allocation shows that more than 50 percent of an average household's wealth is put into bank deposits—it’s in savings. Of the remaining 50 percent, only about 11-15 percent of that goes into equities. The rest is in real estate and other types of assets. That gives them a very solid cushion to take hits that come from a market correction.

The correction has limited overall market effect in terms of wealth. However, it may have some effect in terms of investment psychology and consumer behavior.

ETF.com: Does that mean it makes sense to differentiate between sectors when investing in China? Where is the best opportunity for China investing today?

Tai: Absolutely. Large-caps are the place to be right now. Consider that at the height of suspensions, when about 50 percent of the market was suspended, only about 6 percent of the market cap of the FTSE A50 index—which is the top 50 largest and most liquid companies in China listed on the Shanghai Exchange—was off.

If you look at the broad-based CSI 300, it had 84 stocks out of the 300 suspended. That's almost a third of their stocks. At the same time, we saw almost 70 percent of small-cap stocks being suspended. From a liquidity and volatility perspective, large-cap stocks are most attractive.

From a valuation point of view, large-caps also look good because they didn't have as hard a run-up as small-caps did. The FTSE A50 Index was trading at around 14 times price-to-earnings at the height of the rally in June, whereas the U.S. was trading at around 18, and the broad-based CSI 300 was trading around 22 times price-to-earnings. Now FTSE A50 is at about 10.5 times, and CSI 300 is at about 17.

ETF.com: Is there an arbitrage opportunity between different share classes—H-shares versus A-shares? Should you own both?

Tai: When the rally first starting happening, a lot of hedge funds were trying to put on a long-H, short-A trade. But that trade is basically range-bound between 25 percent at the lowest to now about a 40 percent differential. If you put on that trade from last year until this year, you basically made zero. We've continually said that we have to treat the two markets differently and have allocations to both.

If you're long China, you should be long both A and H. The correlation between A-shares and H-shares is about 0.6. That correlation is actually the same as Hong Kong to the U.S.

ETF.com: Will developing a global reserve status for the Chinese currency make any difference in terms of investment opportunities going forward?

Tai: Absolutely. We've already begun to see China being dominant as an export country, and RMB being moved into one of the most trade-settled currencies in the world. The internationalization of the RMB will create more stability in the market because investors, export/importers and other countries will begin to have more allocation to China. It will also increase accessibility to China’s equities and debt markets.