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Taking a holistic approach to analysing net China exposure

We take a holistic approach to analysing the fund’s China exposure and opportunistically shift net China exposure between ‘A’ and ‘H’ shares and, more broadly, across the different markets in our stock universe. We believe this is a smarter way of monitoring and constraining China exposure, especially compared to a simplistic approach which only considers country of listing. It allows us to generate alpha at the margin (stock selection will always be the fund’s primary return driver).

We explore this issue in detail, first examining ‘A’/’H’ share issue and then looking more broadly at China exposure across the whole portfolio.

‘A’/’H’ exposure

We continually monitor our net ‘A’/’H’ positioning vis-à-vis ‘A’/’H’ share premiums and discounts. Currently, every ‘H’ share in our stock universe is trading at a discount to its ‘A’ share counterpart. The average discount is over 47% and the median discount is almost 45%. They’re the same companies with the same voting and dividend rights and, in most cases, both the ‘A’ and ‘H’ shares are extremely liquid. The only significant difference is the ‘H’ shares have much higher dividend yields, courtesy of their lower share prices.

Consider, China Life Insurance (2628 HK). There are more ‘A’ shares than ‘H’ shares on issue, but the ‘H’ shares are still extremely liquid with a median daily turnover of approximately $US50m per day. As at the time of writing (August 1, 2023), the ‘H’ share closing price was $HK11.90, while the HK equivalent share price for the ‘A’ share was $HK40.30. Incredibly, mainland investors can purchase the ‘H’ share at the discounted price via stock connect and enjoy a much higher dividend yield.

(The only risk is currency conversion. Mainland investors are potentially exposed to adverse movements in the HKDCNY exchange rate. Many ‘H’ shares listed in HK now have a CNY listing, but currently the CNY listed shares cannot be purchased by mainland investors via stock connect. We believe this is likely to change in the future, but it probably won’t make much difference. ‘A’/’H’ share fungibility would be required to erase the discount – and this won’t happen for the foreseeable future.)

Liquidity flows drive the relative performance of ‘A’ and ‘H’ shares. Overseas investors have been reducing their exposure to Chinese equities and this has had a disproportionately large impact on ‘H’ shares.

The following chart shows the performance of the China AH Premium Index since the fund was launched.

The peak occurred in mid to late 2022, around the time of the 20th National Congress of the Chinese Communist Party, when overseas investor bearishness reached its zenith. It subsequently dipped when overseas investors embraced the Covid reopening thematic. More recently, it’s been trending up again.

‘A’/’H’ share price differentials tend to mean revert over the medium term when investor flows normalise, and we believe it makes sense to exploit mispricing opportunities via our net positioning across these stock groupings.

China exposure across our non-China positions

Overall, we are slightly net long Chinese shares based on our “country of risk” analysis (which as we’ve previously discussed considers where companies are based and where they source most of their revenue). This is largely because these stocks look attractive based on our investment process. It’s interesting to note that although ‘A’ shares are expensive relative to ‘H’ shares, they’re still cheap relative to other Asian equities (and incredibly cheap relative to US equities).

To mitigate this risk, we examine the level of China exposure across our non-China positions. It’s interesting to note that investors seem to be highly selective in terms of how they view China risk. They’re deeply concerned about stocks listed in China but don’t seem too concerned about stocks that rely on Chinese demand and/or the assembly of products in China. Two of the largest companies in the world - Apple and Tesla – are interesting examples given their incredibly strong share price appreciation this year despite their

continued reliance on China.

Identifying China exposure across our non-China positions is a semi-automated process. First, we screen for non-China companies based on a field in our database which we source from Bloomberg (PCT_REVENUE_FOREIGN_SOURCES). Among our portfolio holdings, we focus on the top 400 stocks not listed in HK or China. Next, we run a system that downloads into Excel a geographic breakdown of this data (using the following Bloomberg fields "PG_REVENUE", "PRODUCT_GEO_OVERRIDE=G").

Unfortunately, this data is noisy, so it requires some manual work. We look at the Bloomberg data and supplement it with our own insights based on our understanding of each company’s business. We then assign a level of China exposure based on the following classification scheme: Very High, High, Medium, Low/Non-existent.

This data is stored in Conquest, and we aggregate our net exposure across these different categories, as shown below.

We have a net short exposure to stocks listed outside of China which are leveraged to China’s growth and supply chains. We believe this makes sense from a risk perspective (to mitigate a slight net long exposure to stocks listed in HK and China) and from an alpha perspective (given they’ve been relatively unaffected by China macro issues).

Chinese ADR exposure

Previously we also had material short positions in Chinese ADRs – particularly in 2021 when these shares were richly priced – but we currently only have one such short position (in NIO).

There have also been companies with ADR listings which have subsequently listed on the Hong Kong exchange (eg XPENG). When this occurs, we transfer our holding to the Hong Kong listing as these positions are easier to manage from a time zone perspective.

Listing risks

Lastly, we want to highlight that our focus on “country of risk” rather than “country of listing” doesn’t mean we don’t also appreciate listing risks. For example, we recognise that the ‘A’/’H’ share premium could blow out further and China listed stocks could continue to undperform stocks with significant China exposure which are listed outside of China.

Hence our positioning based on these market dynamics is intended to supplement rather than drive performance.

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