Investing in Chinese equities

Few markets have grown as quickly as China’s A-share market - many fear to overvalued levels. The Shanghai Composite index surged 130 per cent in 2006 and almost 100 per cent in 2007, and the Shanghai market alone has a market capitalisation of nearly $3,000bn.

Including the Shenzhen stock market, foreign currency-denominated B shares and Chinese shares listed in Hong Kong, or H shares, the total market for Chinese shares is worth about $4,200bn.

However, 2008 has started poorly for initial public offerings in China and Hong Kong compared with the record year of 2007, suggesting Chinese shares are becoming more correlated to the volatility in global markets wrought by fears of US recession, inflation, and higher oil prices.

While China continues to gradually liberalise flows of capital entering and exiting the mainland, it remains conservative, leaving international investors few options to gain exposure to Chinese companies.

Burton Malkiel, economics professor at Princeton University, author of the classic investment study A Random Walk Down Wall Street and leading advocate of the efficient market hypothesis, proposes several ways international investors can access the Chinese stock market in his new book From Wall Street to the Great Wall.

However, Professor Malkiel warns: “If you think Chinese investments are the way to get rich quick, with all gain and no pain, you may be in for a rude disappointment.” Read an excerpt from the book.

Professor Malkiel believes most investors will be better off participating in Chinese investments through mutual funds and that exchange traded funds (ETFs) dedicated to China are particularly attractive. He answered your questions on Friday, February 29.

Disclosure: Professor Malkiel is chief investment officer for Alpha Shares, which along with S&P, provides the index for the HAO and TAO funds mentioned below. He also has a small holding in the Templeton Dragon Fund (TDF).

Given the nature of the Chinese market, would you agree with the statement that the Chinese stock market is much less efficient than, say, the US market? If so, are there opportunities for sophisticated investors to take advantage of?
Clement Loh, Toronto

Burton Malkiel: The local Chinese stock market – the so called A-share market – is not an efficient market. Managed equity funds tend to outperform the market averages and a number of anomalies characterize that market. However, the Chinese stock market is quite complicated. There are shares of Chinese companies that are also traded in Hong Kong. This is called the H-share market. In addition, shares trade in New York (N-shares), London (L-shares), Singapore (S-shares), etc. I find that the markets that are open to international competition (that is, markets other than the A-share markets) do tend to be more efficiently priced.

One anomaly that illustrates the inefficiency of the A-share market is that when some companies trade both in the Shanghai A-share market and in the Hong Kong in the H-share market (as well as in the United States N-share market) the prices in Hong Kong and New York tend to be the same, but the prices of the same shares typically trade at premiums between 50 and 100 percent in the A-share market. These inefficiencies, however, do not present an opportunity to international investors unless one has one of the limited number of QFII quotas. The A-share market is not generally available for either buying or selling. The market is essentially restricted to Chinese nationals living on the mainland. Local Chinese institutions do take advantage of unsophisticated investors and that is why managed funds in China tend to outperform the market indices.

If the renminbi is going to appreciate by least 10% per annum against the US dollar in the next few years, wouldn’t that in itself be a reason to have an exposure to China?
Robert King, Malaysia

Burton Malkiel: I believe the Chinese Yuan (RMB) is the most undervalued currency in the world today. A good example of that undervaluation is the London Economist’s “Big Mac” index. The London Economist’s prices a Big Mac in nations all over the world to estimate purchasing power parity. A Big Mac sells for $3.00 in New York, over $4.00 in London, and $1.31 in Shanghai.

I believe the Yuan will continue to appreciate against other currencies. The Chinese government is not letting the Yuan float freely, but it has allowed an annual appreciation during the past two years of more than 5 percent against the US dollar. I believe there will be upward pressure on the Yuan for many years to come and I believe that the undervaluation of the currency is one of the many reasons why investors should have some exposure to Chinese equities.

How likely is a major downward correction (>30%) in the China equity markets in the next three years? Can the Chinese government do anything to prevent or mitigate this?
Vincent Siang, Beijing, China

Burton Malkiel: The Chinese stock market is one of the most volatile in the world. It is even more volatile than the Brazilian stock market. A major correction is not only possible, but likely in any three year period. The Chinese government can take some actions to mitigate the volatility. For example, they can restrict the number and amount of new issues, they can release government owned shares to the market more gradually, etc. But I do not believe that the government can prevent market corrections.

Will hot foreign money push up the market first, and then run away, as happened during the Asian crisis in 1997?

Burton Malkiel: Foreign money can move quite rapidly into and out of different countries. Having said that, however, there are two differences in the Chinese situation from those that existed during the Asian crisis of 1997. First, China’s currency is tightly controlled. Second, unlike many of the Asian currencies in the 1990s, the Chinese currency, in my judgment, is undervalued. If markets were completely free, I would expect that a run on the Chinese Yuan would be one of the least likely events in international capital markets, because the Yuan is so undervalued and China has about $1.5 trillion in reserves.

Given the many distortions in China’s stockmarkets - e.g. small free floats, widespread expectation of government intervention if indices drop too low, low standards of corporate governance - to what extent can investors actually make informed decisions about value? And what are they actually buying when they buy a Chinese stock?
NRT, Beijing

Burton Malkiel: There is no question that transparency of Chinese accounting standards, standards of corporate governance, etc., are problematic. However, shares traded in Hong Kong and in other international capital markets must conform to international accounting standards and Hong Kong listed companies have somewhat better corporate governance. Even so, buying Chinese stocks is risky. This is why in my book, From Wall Street to the Great Wall, I recommend a mixed strategy. Perhaps half of one’s exposure to China should come from buying Chinese companies’ stocks that are traded in international markets and the other half by buying international companies with better accounting and governance standards, but whose business is importantly affected by the growth of China. This indirect strategy (buying companies traded in international markets and domiciled abroad that benefit from China) should include an important exposure to commodities. China has had a voracious appetite for raw materials and I believe that will continue as China continues to grow.

I believe the Chinese government will slowly but surely lift controls on the renminbi. What is the best way to deriving benefit from the eventual removal of exchange controls? I have a significant investment in the Power Shares Golden Dragon fund. Drew D Pettus, Bellingham, Washington

Burton Malkiel: As indicated above, an exposure to the better governed, more transparent Chinese companies traded in international markets, will tend to benefit the investor as the Chinese Yuan appreciates.

The Chinese stock market seems to show excessive volatility intraday. Is this a true observation and if so why does it occur?
Chris Stewart, Cape Town

Burton Malkiel: The Chinese market does show excessive volatility, not only intraday, but also from week to week and year to year. This is especially true of the A-share market and this does indicate a lack of efficiency.

With its swollen foreign exchange reserves, it wouldn’t make much sense for China to woo portfolio investors, as this would only add upward pressure to its appreciating currency. Is it under any obligation to liberalize its capital market?
Umnuay Sae-Hau, Bangkok

Burton Malkiel: China is not obligated to liberalize its capital market and free its currency. However, there are considerable political pressures from both the US and the European Union to have them do so. For example, during the recent debate between presidential candidates Barack Obama and Hillary Clinton, Clinton again repeated the often heard claim that China is a currency manipulator and must let its currency appreciate more rapidly.

Do you think the premium A share market is enjoying now compared with H share market is reasonable considering the liquidity in A share market?
Jessica Zhang

Burton Malkiel: I do not think the premium in the A-share market over the H-share market is justified. It violates “the law of one price.” There is no reason to think that China Life should sell for double the price in Shanghai than it does in Hong Kong. The only reason for this is that Chinese citizens cannot exchange their Yuan for Hong Kong dollars and buy China Life in the Hong Kong market. Moreover, currency restrictions prevent an arbitrage between the two markets.

Is there any correlation between the Olympics and Chinese stocks?
Johnny Zhang, UK

Burton Malkiel: I think there could be a correlation between the Olympics and the Chinese stock markets. I do not make short term predictions about any stock market, but I do believe, as we get closer to August 2008, there will be increasing publicity about the Olympics and possibly considerably more international interest in China and in Chinese stocks.

Do you think it would better to own a few Chinese ADS/ADRs traded on the NYSE for two to three years, or buying the China-focused ETFs for the same period?
Angelo Park, Chicago

Burton Malkiel: I believe that the Hong Kong market and the market for Chinese stocks in New York are reasonably efficient. I do not find that managed funds investing in H and N shares do better than some of the indexed ETFs. I therefore favor low cost ETFs that give investors a Chinese exposure. Such ETFs include: FXI, an index fund that tracks the FTSE/Xinhua large-capitalization index; GXC, an ETF of H and N shares; TAO, an ETF of Chinese property development companies; and HAO, an ETF of Chinese small capitalization companies. It is also the case that recently some closed in China funds have been selling at substantial discounts. If a fund such as the Templeton Dragon Fund is selling at a 20 percent discount, this would be a useful way of accessing a portfolio of H-shares. I would not, however, buy the ETF CAF, even though it does trade at a substantial discount. This ETF invests in A-shares, which I believe are overvalued relative to H-shares.

I invested £5000 in November in a unit trust which has now lost £1300. This was previously the best performing China fund sold in the UK. Should I sell or hold?
J Philpott, Dymchurch, Kent, UK

Burton Malkiel: Because of the enormous volatility of Chinese stocks, I do not recommend that any investment be made at a single time. If one had £5000 to invest, I would much prefer to put £1000 into the market every one or two months, rather than investing it all at once. Investing it all at once runs the risk of putting one’s investment into the market at a peak in market prices. I also believe that investors in Chinese stocks should plan on a very long holding period. Over the next five to ten years, I believe even an investment made in November 2007 will prove to be profitable.

I have seen numerous articles on Bloomberg about maids in Shanghai giving up their day-jobs to trade stocks. Is this not the surest sell signal there is?
Steven Dutaut, London

Burton Malkiel: There is no question that the A-share market in Shanghai and Shenzheng is extraordinarily speculative and inefficient. This is why I do not recommend a purchase of Chinese A-shares.

Significant numbers of companies traded on London’s Alternative Investment Market claim to have significant exposure to China, especially the growth of private, entrepreneurial companies rather than giant industrial concerns subject to constant state meddling. How viable do you think these companies are as a way of investing in China? Are they truly China proxies, or do they just move in lock-step with other UK small-caps (and right now, that’s down)?
Jonathan Eley, UK

Burton Malkiel: As indicated above, I do believe that an indirect strategy of purchasing non-Chinese companies that benefit from China’s growth is a useful low risk strategy for investors. These companies could be small entrepreneurial companies or even large international firms such as General Electric, LVMH, and BHP Billiton. It is also the case that there are a number of private smaller entrepreneurial Chinese companies, where government ownership tends to be low or non-existent. As indicated above, these kinds of companies can be accessed through the HAO exchange traded fund. Recently, all markets have been under stress and have tended to move together. In the long-run however, I believe investors will be rewarded by having some direct and indirect exposure to the growth of China.

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