China’s New Economy: A Source of Uncorrelated Equity Returns (Australian Edition)

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Given the lackluster performance of Chinese equities in 2021, Australian investors may be questioning the value of having a dedicated exposure to the asset class in their portfolios. The CSI 300 Index, a benchmark of the largest companies in China that trade exclusively on domestic exchanges in Shanghai and Shenzhen, was down 1.7% through October, including dividends (in AUD). The MSCI China Index, a benchmark of mostly Chinese companies listed on U.S. and Hong Kong exchanges (Alibaba, Tencent, Baidu, JD.com, Didi to name a few) fared worse, losing 11.9% in the first 10 months of the year (also including dividends)[1].

For investors in Australia, whose patience with China might already be wearing thin given the country’s punitive economic measures against Australian exports—including tariffs on iron ore, coal, wine, barley, timber, beef, and lobsters implemented last year—it might be prudent to take an unbiased look at the data before removing one of the best sources of uncorrelated returns from their investment toolkit.

On the surface, replacing a dedicated allocation to China with an allocation to emerging markets (EM) might seem a better way to diversify a portfolio’s equity exposure, yet nothing could be further from the truth. Not only has EM returned a paltry 4% per year as measured by the MSCI EM Index since 2008, but in terms of diversification or risk-reduction, EM returns look no different than developed markets returns. Indeed, the MSCI EM Index has a correlation of 0.66 with the ASX 200 while the MSCI EAFE has a correlation of 0.65 with the ASX 200[2]. Thus, an allocation to EM within an Australian equity portfolio would have decreased returns while providing no additional diversification benefits relative to an allocation to global developed equities.

On the other hand, an allocation to U.S. equities would have enhanced returns and provided some diversification benefits to Australian investors. The S&P 500, a broad U.S. benchmark, gained 12.1% per year since 2008, with a correlation of 0.49 with the ASX 200. However, most Australian investors already have a significant allocation to U.S. equities, thereby negating the diversification benefits of further allocating to that asset class (increasing concentration in U.S. stocks).

So where do investors holding Australian and U.S. equities in their portfolios go for diversification? The answer is onshore Chinese equities, but perhaps not through the broad, traditional benchmarks. The MSCI China Index, comprised mostly of Chinese stocks listed offshore, had a correlation of 0.37 to the ASX 200 Index and 0.28 to the S&P 500 Index. But with an annualized return of 4.3%, it performed no better than the MSCI EM Index, making investor skepticism about this exposure totally understandable. On the other hand, the MSCI China A Onshore Index, a measure of China’s domestic market, had an even lower correlation to both the ASX 200 and the S&P 500, at 0.18 and 0.25 respectively. Unfortunately, this came with a paltry annual return of 2.9%, including dividends.

China’s New Economy and the Value of Onshore Stock Selection

As regular MarketGrader readers may recall, we have alluded to the paradox in the Chinese equities market before. Despite China’s equity market having more than doubled in size in the last decade to become the second largest in the world by market capitalization (when the Shanghai and Shenzhen markets are combined), investors owning the broad market have failed to earn any return after inflation[3]. Chinese equities have simply failed to translate the country’s economic growth into shareholder returns. This has caused many growth-minded global investors to skip an allocation to Chinese equities altogether.

A deeper dive into the Chinese economy reveals that China’s market has largely bifurcated into what many now refer to as ‘old’ and ‘new economy’ stocks, with the former category including financials, energy, materials, industrials and utilities and the latter including the consumer, health care and technology sectors. In short, while the performance of the old economy may be stagnating in terms of stocks returns, the new economy companies are growing. Therefore, investors exposed to both Australian and U.S. equities needn’t settle for paltry returns in order to diversify their portfolios. They can partake in both—returns and risk-reduction.

The MarketGrader China New Economy Index (MGCNE), tracked by the VanEck China New Economy ETF in Australia since 2018, is a benchmark of Chinese new economy companies with strong fundamentals based on MarketGrader’s GARP selection process.  As of the publication of this blog, MGCNE has had an annualized return of 13.7% (in AUD) since its inception on December 31, 2007 – outperforming both the ASX 200 and the S&P 500.  But the better news is that MGCNE has had a correlation of only 0.08 to the ASX 200, 0.18 to the S&P 500 and 0.15 to the MSCI EAFE Index, meaning that it provides all of the diversification benefits without sacrificing the upside.  

  Figure 1a. Annualized Returns for MGCNE Compared to ASX 200 and Select Global Indexes

IndexSince Inception10 Years5 Years3 Years
S&P ASX 200 Index5.5%10.0%10.9%11.9%
S&P 500 Index12.1%20.3%19.2%19.1%
MSCI EAFE Index4.8%11.7%10.6%9.9%
MSCI EM Index4.0%8.9%10.1%10.5%
MSCI China Index4.3%11.5%10.7%9.5%
MSCI China A Onshore Index2.9%10.8%9.3%22.7%
MarketGrader China New Economy Index13.7%16.6%9.0%24.6%
Sources: FactSet (all benchmarks), Bloomberg (MarketGrader China New Economy Index).

     Figure 1b. Correlations Matrix for Select Benchmark Returns Between 2008 and 2021

 ASX 200S&P 500MSCI EAFEMSCI EMMSCI ChinaMG CNEMSCI China A
ASX 200 Index1.000.490.650.660.370.080.18
S&P 500 Index1.000.780.440.280.180.25
MSCI EAFE Index1.000.650.420.150.23
MSCI EM Index1.000.760.270.41
MSCI China Index1.000.460.61
MG China New Economy Index1.000.80
MSCI China A Onshore Index1.00
     Source: MarketGrader

Figure 2. Three-Year Rolling Correlations with the ASX 200 Index for Select Benchmarks

Source: MarketGrader

As an illustration of these twin benefits consider Figure 3. It presents two portfolios comprised of two asset classes – Australian equities and Chinese equities as benchmarked by the ASX 200 and MGCNE, respectively. Portfolio 1 allocates 25% to MGCNE and 75% to the ASX 200, while Portfolio 2 is an equal mix of both. The portfolios are assumed to be rebalanced to the normal weights annually. Starting in January 2008, through October 2021, a portfolio allocated 100% to the ASX 200 gained 109.1% on a cumulative total return basis. This translates to total an annualized return of 5.5% over the period of 13 years and 10 months. Portfolio 1, with an allocation of 25% to MGCNE, would have gained 194.8% over the same period, which translates into an annualized return of 8.1%. Portfolio 2, with an equal allocation to the ASX 200 and MGCNE, would have returned 290.7%, or 10.4% annualized over the same period.

        Figure 3a. Hypotehtical Portfolios Allocated Between ASX 200 & MGCNE, 2008-2021

Calendar Year ReturnsMG China New EconomyS&P ASX 200 Mix 25/75Mix 50/50
2008-31.4%-38.4% -36.7%-35%
200980.3%37.0% 47.9%59%
201019.8%1.6% 6.1%11%
2011-22.6%-10.5% -13.5%-17%
20126.2%20.3% 16.8%13%
201358.1%20.2% 29.7%39%
201425.9%5.6% 10.7%16%
201588.4%2.6% 24.0%46%
2016-19.1%11.8% 4.1%-4%
20177.1%11.8% 10.6%9%
2018-20.7%-2.8% -7.3%-12%
201941.2%23.4% 27.8%32%
202028.2%1.4% 8.1%15%
2021 (ending October)3.8%14.7% 12.0%9%
Cumulative490.0%109.1% 194.8%290.7%
Sources: FactSet (ASX 200 returns); Bloomberg (MGCNE returns); MarketGrader (portfolio mixes).

       

       Figure 3b. Cumulative Returns for Hypothetical ASX 200 & MGCNE Portfolio Mixes

Sources: FactSet (ASX 200 returns); Bloomberg (MGCNE returns); MarketGrader (portfolio mixes).

  

[1] All returns cited in this article are based on gross total returns, which include dividends, and calculated in Australian dollars (AUD). Source: FactSet.

[2] Correlations based on total monthly returns between January 2008 and October 2021. Source: MarketGrader.

[3] Based on China’s stock market growth between 2009 and 2019 and on annualized returns for the CSI All Share

Index. Source: The Chinese Equity Market Paradox, MarketGrader 2020.

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