(To Fish a Needle from the Sea)
With global markets in “freefall” (facing a spot of volatility), what better time to dive deeper into one of the largest fallers year to date: the Chinese equity market.
Luckily for us, our job isn’t to time markets, rather, we are focused on identifying skillful investors that can take advantage of the opportunities offered up by Mr. Market: something we find somewhat easier to assess. As Tom Baird highlighted in our first blog, China seems like a great place to look for active equity managers.
Nick Samuels, Tom Baird and I travelled to Hong Kong, Shanghai and Beijing to put our theory to the test.
When selecting fund managers, it’s important to know what you are looking for. While the characteristics of a successful investment manager are enduring, we always start with the end in mind. This leads us to consider the nuances of every market we are investing in. By our reckoning, there are three major ways to access the China A Share market, all of which are affected by these nuances in different ways:
- The Local Mutual Funds: Large institutions managing mainly Chinese retail money
- The Onshore Private Funds: Privately owned Chinese firms with mainly high net worth, banking and insurance clients (mainly Chinese)
- The Offshore International Funds: Firms based outside of China with mainly international clients
We decided to meet with a broad selection of these managers to build our context of the market environment. All in all, we’ve met with over 40 Chinese equity managers so far.
It wasn’t all plain sailing. Here are some of the key issues that we faced:
– Vast universe of funds and huge volatility means there is a lot of luck is masquerading as skill.
The first thing that struck us was the sheer size of the ocean: there are over 1500 mutual funds and tens of thousands of private fund managers!
Anytime we see such a large pool of investors, alarm bells go off and Dilbert comes to mind.
We soon got used to seeing >10% annualised alpha.
Portfolio manager experience and team turnover
– Fast growing market allows inexperienced investors to set up funds and raise capital.
With lots of capital flowing into the market and investors being very focused on short-term performance, analysts and portfolio managers with little experience have been able to raise material amounts of money. Retaining staff is very difficult, especially within the mutual funds who have limited levers to pull to align staff.
In the past we’ve found little evidence that very experienced portfolio managers have an advantage over less experienced managers. However, if we defined less experienced as <5 years’, we may have come to a different conclusion!
– Retail investors dominate the market and their focus on short-term performance impacts the behaviour of investors.
If your client base is predominantly local retail investors, it’s hard to invest with a long-term horizon. Retail investors trade funds like penny stocks and so a year can be a lifetime in the career of a Chinese equity manager. The high net worth clients and some domestic institutions don’t appear to be much better behaved when it comes to long-termism.
The result, unsurprisingly is an extreme version of the short-termism we observe in other equity markets. It was not unusual for us to see 400-500% turnover strategies even with managers claiming to have a 3-year time horizon.
-There is a culture of high fees so it’s important to leverage your position as stewards of long-term capital.
Fees were a real throwback to the past. Many managers quoted 2 and 20% fees for long only funds that use cash for downside protection. Structures like hurdle rates, high watermarks or relative benchmarks seemed a secondary consideration for many.
Our secret sauce
Separating skillful investors from lucky investors can be hard work but we have a way of navigating that keeps us on track. A crucial part of Redington’s Manager Research approach is assessing the investment philosophy that underpins the team’s approach. We ensure that we are partnering with managers who can articulate the behavioural underpinnings of the philosophy and understand the key determinants of the success of the approach. Fortunately for us, we could wade through the water with relative ease using this framework.
When a market is as inefficient as China A, with a relatively sensible philosophy a manager should be able to generate a healthy level of alpha over the long-term: Huge stock dispersion, massive volatility and a large portion of the market behaving sub-optimally!
We are pleased to have found some needles (fund managers) that demonstrate many of the characteristics we are looking for and are excited about the opportunity to offer our clients access to an inefficient market that can help them move closer towards financial security.
Sources: Dilbert, Taikang, Wind