Clients often ask us whether factor insights can be applied to construct equity portfolios in a particular market. They wonder whether certain market or economic characteristics might prevent factors from working: Different countries and their equity markets are at different stages of development, have different depth and may have dominant sectors. With the partial inclusion of China A shares in the MSCI Emerging Markets Index, the efficacy of active systematic strategies in China likely becomes an important question for investors. We explore whether the China A shares market has distinctive characteristics that lend themselves to factor investing strategies.
China remains a fast-growing economy, whose equity market is characterized by higher volatility and shorter cycles than other markets. While the A-shares market has been traditionally dominated by domestic retail investors, the participation of institutional and international investors is growing.
As Zhen Wei explained his blog post, modern finance theory suggests that factors are persistently rewarded because of behavioral biases, institutional constraints or underlying risks. These reasons exist across markets, but their relative importance may be different depending on typical investor behavior, regulations, the extent of institutional participation and the macroeconomic environment in different countries. This leads to differences in factor performance. There are also influences specific to China, such as government policies and internationalization, that affect factor behavior in China.
We compare risk-adjusted factor performance from our new China A shares model (CNE6), Global Equity Model (GEMTR) and Emerging Markets model (EMM1) over the past 10 years. We group factors related to a common theme into factor families, for example the quality family includes leverage, earnings variability, earnings quality and profitability factors, which are all related to a typical definition of a high quality stock.1
Long-term Information ratios of style factors in China A, Global and Emerging Markets
Data from March 2008 to March 2018
Our key takeaways:
- The illiquidity premium was stronger in China A shares versus global and emerging markets (indicated by the negative return of the liquidity factor).
- The performance of the analyst sentiment factor has been stronger compared to global markets.
- Growth had stronger risk-adjusted returns in China A shares than in the broader regions.
- While traditional momentum was weaker in A shares, short-term reversal and seasonality effects were stronger.
- Value performance was generally less strong compared to emerging markets, though on par with global markets.
- The performance of quality-related factors was less strong compared to EM and DM.
- There was a stronger small-cap premium in A shares compared to global and emerging markets (indicated by the negative return of the size factor). Mid caps tended to under-perform in A-shares, unlike EM and DM.23
In recent years, there were several changes in factor performance. Earnings quality started to perform more in line with global markets. Earnings yield emerged as a strong performer in the value family. The traditional price momentum factor underperformed in A shares, both in absolute terms, as well as relative to global and emerging markets. These changes may reflect the continuing institutionalization of the market, as value and quality strategies are more closely followed by longer-term, fundamental driven institutional investors.
Recent Information Ratios of Style Factors in China A, Global Market and Emerging Markets
Data from October 2015 – March 2018
Factor strategies have historically worked across markets and geographies because the underlying reasons why factors are rewarded exist across markets. Typical investor behavior, regulations, institutional participation and the macroeconomic environment in different countries may influence the strength of factor premia. The unique characteristics of China A shares historically led to a different factor return profile compared to global and emerging markets. Having the right model is critical: A model calibrated to a broad emerging market universe may miss the unique patterns of factor behavior in China.
1 The logic of grouping related factors into factor groups is used in the MSCI FaCS and MSCI FactorLab.
2 The charts reflect the performance of pure factor strategies. These are theoretical long-short portfolios that have unit exposure to the target factor and are neutral (have zero exposure) to industries and the broad market. Strategies with investability constraints (e.g., long-only, limited number of assets, limited turnover) may have lower information ratios
3 The Emerging Markets model (EMM1) does not have earnings variability, profitability, long term reversal and analyst sentiment factors.