Premia Partners: Time to make a smart move in China A-shares

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This is a sponsored article from Premia Partners.

 

As the world celebrates Professor Richard Thaler’s Nobel Prize for contributions to behavioural economics, we thought it timely to reflect on another piece of research – “Anomalies in Chinese A-shares” – co-published by Dr. Jason Hsu, founder of Rayliant Global Advisors and Research Affiliates. The paper reviews well-studied global factors, how they perform in China versus the United States, how their drivers of return are different in the two markets and if smart beta works in China.

Despite the hype in recent years, smart beta and factor investing are neither magic nor new. Rather, they are the index product implementation of academic literature on well-studied sources of excess returns, such as behavioral anomalies and risk premia.

Active fund managers have been using factor screens to generate outperformance for decades. And now, research allows us to implement those same factors into cheaper and transparent index products.

Dr. Hsu begins by pointing out that alpha is a zero-sum game. Generating alpha requires an understanding of the competing traders and their behavioural mistakes. Unlike in developed markets, Chinese retail investors account for nearly 90% of trading. They don’t have the same experience or resources as professionals, nor do they undertake similar levels of research. As a result, they tend to overpay for growth and high beta stocks while constantly chasing momentum via mobile trading apps.

It is thus unsurprising that in China, the mistakes and behavioural anomalies of retail investors supply professional investors with alpha.

So, does smart beta work in China? It does indeed, but not through copying and pasting global models. Dr. Hsu’s research finds that some factors work well (size, low volatility) while others need to be adjusted (value, accounting conservatism) and, in some cases, even work in the opposite direction despite wide usage by many investors (momentum).

Investors should also be wary of overexposure to any given factor, especially if it has done well in the last 3 years, as strategies in China often become overcrowded. Factors mean revert just like other strategies, meaning that if everyone chases recent factor performance, the factor’s valuation is likely too high and ripe for a correction. A multi-factor approach would be more prudent for investors than engaging in factor timing.

 

Today’s A-shares investors have 3 options: 1) pick among the 3,000+ stocks themselves, 2) pay high fees to active managers, or 3) use narrow A-shares beta strategies while still paying an average expense ratio of 1%. These beta strategies utilize a market-cap approach, resulting in concentrated allocations (~60% financials for FTSE A50 and ~60% SOEs for CSI 300) and a tendency to buy-high and sell-low, chasing valuations set by retail traders. As a result, balancing China’s mainstream economy versus its ‘new’ economy is impossible in a beta framework.

Premia Partners is addressing these challenges by implementing Dr. Hsu’s research in the world’s first multi-factor A-shares ETFs. These ETFs not only provide granular exposure to China’s two-speed economy, allowing investors to choose between bedrock and new economy strategies, but also seek to capture excess return by amplifying the factors that work in China. To top it off, the ETFs are 100% physical using Stock Connect and have an expense ratio cap, making them among the most cost-efficient instruments available for A-shares exposure.

Time to make a smart move indeed.

Notes:
The research paper by Dr. Hsu et al. titled “Anomalies in Chinese A-shares” can be found on SSRN and will be published in the upcoming Journal of Portfolio Management.

Premia Partners ETFs will be listed on the HKEx on Oct 24th, 2017 under ticker codes 2803 HK (Bedrock) and 3173 HK (New Economy).

This is a sponsored article from Premia Partners.

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