Weekly brief

ALPHA POTENTIAL FOR CHINA-FOCUSED HEDGE FUNDS

There are structural reasons why Chinese equities provide a fertile ground for alpha. First, flows into China would support both beta and alpha. China accounts for only 8.5% of the world market cap, in contrast with its 16% share of the world GDP or 10% of world capex. A widening market access and a heavier share of China in EM and global indices will attract flows. Second, market depth, essential for alpha, would improve thanks to a richer set of businesses, types of investors and corporate operations. In particular, state-owned enterprises’ capitalization now accounts for less than 40% of total (~100% a decade ago). It makes room for more private companies now accessible via the Stock Connect, with a healthy pipeline of IPOs. While far from DM’s, the free float percentage is growing (~40% today), improving minority shareholders’ safety and liquidity. The A-shares market, still dominated by retail flows and driven by momentum, does provide arbitrage potential but remains vulnerable to correlation risk. Rising institutional ownership, including foreign investors and pension funds, would offer more stable alpha. Stock shorts – still heavily regulated – remain encouraged, which also increases market depth while tempering investors’ exuberance. Third, multiple themes provide numerous catalysts, including the transition from an export to a consumption driven model with a stronger middle class, a rapid urbanization, the rise of innovation leaders in tech and beyond, an ageing population, industrial consolidation in sectors facing excess capacity, the improvement in corporate governance. Foreign stocks sensitive to China also offer safer proxies to capture domestic trends (highly correlated until the trade war, these stocks outperformed Chinese indices since then).

Structural challenges call for specialists. Uncertainty regarding trade policies, supply chains, foreign market access, CNY trends might persist for longer. Moreover, Chinese markets remain policy-driven with vulnerability to changes in economic stimulus, credit access, regulations, state control over SOEs, stock suspensions. Elevated corporate debt also calls for serious risk management, as well as rising instability in Hong Kong.

The current alpha backdrop could improve in a trade truce scenario. Alpha generation has been volatile over the last two years, impaired by the dominance of trade and tech wars. Poor fundamental pricing is apparent in the high share of stock moves attributable to broad markets. Yet, multiple themes and uneven impacts from trade policies result in low stock correlation, limited sector leadership and greater price discrimination. Besides, stocks ;are cheaper providing stock-picking potential. Moreover, prospects of a trade truce are opening fresh opportunities, while our tactical indicators don’t point to a major risk of reversal.

In a trickier backdrop, managers favor cautious ,exposures (<0.5 of beta). Over time, we estimate that alpha contributed to 40% of their returns, from market-timing and bottom-up selection, rather than from factor investing (not a decisive driver in China). The average funds’ return correlation across our basket of China L/S Equity funds reflects a healthy pool of opportunities.

A trade truce would improve mixed current alpha conditions. In the long-run, passive and active styles seem both fit to get Chinese exposure. Yet, as market return moderate, a rebalancing toward active strategies would gain traction.

Soft manufacturing surveys are bottoming out, pointing to a turn in hard data. Monetary accommodation and less uncertainty on most trade fronts have been key contributors to this inflection, as well as front-loading ahead of the September tariffs. A modest global economic bounce in Q1 seems credible, conditioned by the confirmation of trade hopes. First, the manufacturing recession hasn’t reached the point of no return, evidenced by resilient services and consumption. Second, global liquidity will remain supportive, boosting credit, capex and consumption. Third, while stabilization in Chinese real activity has been delayed by September tariffs, stimulus efforts and a possible rollback of some tariffs are paving the way for a modest bounce. Finally, a Brexit deal would also modestly boost EU/UK investment.