Practical analysis for investment professionals
14 February 2018

Navigating a China Dip

Visiting Hong Kong for the first time in two decades, I see evidence of breakneck economic transformation everywhere: swathes of new skyscrapers, enticing shopping malls, filled with outlets selling nothing but luxury watches, and everywhere a crush of cheery tour groups from China’s booming mainland.

Someday the music may stop. That fear sent global central banks and markets pivoted on Chinese growth into panic when China last suffered an economic hiccup in 2015. A recent IMF working paper, “Credit Booms — Is China Different?” published last week on the new regional ARX platform from CFA Institute, suggests that a downturn is inevitable. A generation of young investors unschooled in market volatility may receive an unpleasant shock.

China is proactively reforming to refocus its economy from cheap exports to domestic consumption, but strict capital and currency controls and investor flight risks remain. According to one recent study reviewed in the CFA Institute Financial Analysts Journal, The limited degree of internationalization of the Chinese currency, the renminbi (RMB), means the US dollar is likely to remain the pre-eminent safe haven currency for most investors.

That said, Chinese investments denominated in RMBs, which usually look undervalued when measured using country-specific factors, don’t appear in most institutional portfolios. Hong Kong, with its US dollar peg and sizeable Exchange Fund, seems likely to weather any slowdown on the mainland, and some market and trading activity has anyway migrated from Hong Kong to mainland cities.

Avoiding Home Bias 

The traditional solution to cyclical swings is for investors to diversify among sectors and countries. But will this work if China leads a multimarket drawdown? Global equity funds outperform their benchmark by 1.2% to 1.4% a year before fees, a study in the Financial Analysts Journal demonstrates. In contrast, another study from the Journal of Financial Economics, summarized in CFA Digest, finds that institutional portfolios that concentrate on their home country or a few select foreign countries, as well as industries, achieve higher risk-adjusted returns than a fully diversified world-market portfolio, in part because of information advantage.

Cross-border company operations complicate efforts by investors to avoid home bias according to a new article, “Mononationals: The Diversification Benefits of Investing in Companies with No Foreign Sales,” published in the Financial Analysts Journal and summarized in an In Practice article. The authors suggest that a portfolio of mononationals offers the potential for greater benefits than a portfolio of multinationals.

New Techniques 

It matters not only where but how you structure your international portfolio. If you are indexing then beware reclassifications from one index to another that may require you to react. A new Financial Analysts Journal study by a trio of researchers, also summarized in the In Practice series, finds that the prices of reclassified markets substantially overshoot between the announcement date and the effective date.

Quantitative factor investing works internationally not just in the heavily researched US markets according one recent study, summarized in CFA Digest, by Eugene F. Fama and Kenneth R. French. Average stock returns for North America, Europe, and Asia Pacific increase with the book-to-market ratio (B/M) and profitability factors and decrease with the investment factor. For Japan, only the relationship between average returns and B/M is strong. In Hong Kong, according to a working paper published on the CFA Institute ARX platform by S&P Dow Jones Indices, factor portfolios tend to be sensitive to the local market cycles and in India while some single-factor portfolios outperform, they experienced periods of underperformance under some market regimes.

Diversified Investment Techniques, Stocks, and Products

At the regional diversification level, Multi-Asset Strategies: The Future of Investment Management, edited by Larry Cao, CFA, describes the concepts of risk factor allocation and dynamic asset allocation along with a range of regional case studies. On the product level, a new Research Foundation Brief, “Asian Structured Products” by Angel Wu and Clarke Pitts, examines the nature of regional structured products, why they are used, and by whom.

When it comes to stock picking in China, CFA Digest has summarized a new study from the International Journal of Accounting, “Do Foreign Directors Mitigate Earnings Management? Evidence from China,” that suggests companies with foreign directors on Chinese boards are linked to lower earnings management, although that may not apply to the state sector. Meanwhile, another study from the Journal of Corporate Finance, summarized in CFA Digest, explores the relationship between political connectedness and heightened merger activity.

Finally, there is support for gold, perhaps the ultimate hedge against a China dip, in “The Truth about Gold: Why It Should (or Should Not) Be Part of Your Asset Allocation Strategy,” by Campbell Harvey. If China were to bring its gold reserves up to international norms, it would end up purchasing almost all of the existing global gold ever mined. This seems to underpin the case for portfolio diversification in precious metals, the subject of a new Financial Analysts Journal article and companion In Practice summary that explore the best route to accomplish portfolio diversification using precious metals.

Further Reading on China and the Asia-Pacific Region

Credit Booms – Is China Different?

A recent working paper from the IMF titled “Credit Booms — Is China Different?” provides a good summary of many of the key issues facing China’s economy. Rapid credit growth since the global financial crisis is record setting for both its total expansion and its duration. Credit is being poorly used with the most inefficient sectors and firms grabbing large shares of new debt.

The Truth about Gold: Why It Should (or Should Not) Be Part of Your Asset Allocation Strategy

Most arguments for holding gold in a portfolio are not supported by an analysis of the data, Campbell R. Harvey observes. Nonetheless, an argument can be made for including gold as a commodity in a well-diversified portfolio, particularly if investors and central banks increase their demand — even moderately — for gold.

International Tests of a Five-Factor Asset Pricing Model

A new five-factor asset-pricing model is tested with international data. Eugene F. Fama and Kenneth R. French find that average stock returns for North America, Europe, and Asia Pacific increase with the book-to-market ratio (B/M) and profitability and decrease with investment.

Do Foreign Directors Mitigate Earnings Management? Evidence from China

Xingqiang DuWei Jian, and Shaojuan Lai find that a higher proportion of foreign directors on Chinese boards helps mitigate earnings management, but the effect is less pronounced in state-owned enterprises, where political force may substitute for the benefits of board diversity — advising and monitoring — that foreign directors bring to an organization.

Portfolio Concentration and Performance of Institutional Investors Worldwide

Institutional portfolios exhibit a home bias that causes them to overweight home market stocks and underweight foreign stocks, according to Nicole ChoiMark FedeniaHilla Skiba, CFA, and Tatyana Sokolyk. Institutional portfolios that concentrate on the home country or a few select foreign countries, as well as industries, achieve higher risk-adjusted returns than a fully diversified world market portfolio.

Currency Value

Real exchange rates can predict currency excess returns, Lukas MenkhoffLucio SarnoMaik Schmeling, and Andreas Schrimpf report, and this predictive power becomes stronger when expanded to include such country-specific factors as productivity, export quality, net foreign assets, and output gaps.

Sovereign Debt Ratings and Stock Liquidity around the World

Kuan-Hui LeeHoracio Sapriza, and Yangru Wu examine the effects of sovereign bond rating changes on the liquidity of stocks in 40 countries. They find a strong relationship between stock liquidity and negative rating changes. They also find that positive rating changes have no significant effect on liquidity.

Mononationals: The Diversification Benefits of Investing in Companies with No Foreign Sales

Few papers have focused on the diversification benefits of companies with domestic sales only, or mononationals. Cormac Mullen and Jenny Berrill compare the international diversification benefits of equity portfolios of various multinational classifications.

Indexing and Active Fund Management: International Evidence

A key pillar in the active versus passive management debate is the positive impact that index-tracking alternatives can have on the performance and behavior of active fund managers. Martijn CremersMiguel A. FerreiraPedro Matos, and Laura Starks demonstrate improved competition in markets where explicit indexing is more common.

The Impact of Foreign Trades on Emerging Market Liquidity

From January 2008 to December 2010, aggressive foreign investor–initiated trades on the Indonesian Stock Exchange aided the price discovery process but increased the degree to which individual stocks’ liquidity tracked overall market liquidity, Yessy PeranginanginAkbar Z. AliPaul Brockman, CFA, and Ralf Zurbruegg report.

Investing in the Presence of Massive Flows: The Case of MSCI Country Reclassifications

Almost $10 trillion is benchmarked to MSCI’s developed, emerging, frontier, and stand-alone market indexes, according to Terence C. BurnhamHarry Gakidis, and Jeffrey Wurgler. Reclassifications from one index to another require thousands of investors to decide how to react.

Multi-Asset Strategies: The Future of Investment Management

In this book, edited by Larry Cao, CFA, Part I focuses on the concepts of risk factor allocation and dynamic asset allocation. Jason Hsu of Research Affiliates and Rayliant Global Advisors and Brian Singer, CFA, of William Blair & Company address these topics, respectively. It also includes a chapter on risk parity by Gregory Allen of Callan Associates as well as a chapter on the Morningstar Style Box by Jeffrey Ptak, CFA. Part II includes a few case studies illustrating how institutional investors manage multi-asset strategies.

Do Global Equity Funds Outperform?

Recent research published in the Financial Analysts Journal investigates the performance of active global equity funds and the source of any outperformance, Mark Harrison, CFA reports. The authors find that, on average, global equity funds outperform their benchmark by 1.2% to 1.4% a year before fees. The study has several practical implications for investors.

Gaining Currency: The Rise of the Renminbi (a review)

This work by Eswar Prasad is effectively two books in one: (1) an account of the rise and internationalization of the renminbi and of its prospects for continued ascendancy over the near term and the medium term and (2) a concise description of the various vehicles for investing in Chinese assets.

Asian Structured Products

In this paper, Angel Wu and Clarke Pitts examine the nature of structured products, why they are used, and by whom. They consider the size of the industry and some of its most popular products in the context of Asian capital markets. Finally, they identify a variety of risks for each of the parties involved: issuers, intermediaries, and investors.

Friends in the Right Places: The Effect of Political Connections on Corporate Merger Activity

Firms often work with politicians and former regulators to navigate the corporate world — in particular, mergers and acquisitions. Stephen P. FerrisReza Houston, and David Javakhadze explore and establish the nexus between political connectedness and heightened merger activity.

How Smart Beta Strategies Work in the Hong Kong Market

In this working paper, the authors analyzed the performance of six single factors (small cap, value, low volatility, momentum, quality, and dividends) in the Hong Kong market from 30 June 2006, to 28 February 2017.

Factor Performance Across Different Macroeconomic Regimes in India

For this working paper, the authors compared sector composition in factor portfolios and examine performance characteristics of factors in different macroeconomic regimes, including market cycles, business cycles, and investor sentiment regimes in India.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

Image credit: ©Getty Images/Yiqing Cao/EyeEm

About the Author(s)
Mark Harrison, CFA

Mark Harrison, CFA, was director of journal publications at CFA Institute, where he supported a suite of member publications, including the Financial Analysts Journal, In Practice summaries, and CFA Digest. He has more than 12 years of investment experience as a portfolio manager and securities analyst. Harrison is a graduate of the University of Oxford.

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