The outperformance of the size, value, and reversal factors is strong, but the momentum factor, which has performed well in the U.S., does not work in China. This is the conclusion of a new white paper published by Neuberger Berman about quantitative investing in China A shares.
It has a bottom line, or rather two bottom lines, one about “whether” and the other about “how” to use the quant toolbox in China. First, the report, from Neuberger’s Ping Zhou, contends that the “opportunity set” offered by such shares may be “as rich as that of the developed markets 20 years ago, in the heyday of quant investing.” But as to the how—simply “transporting U.S. equity factor models to this new market” is the wrong way to go about it.
For foreign investors, Chinese equity presents in a lot of different tents as in a county fair: A shares, B shares, H shares, Red-chips, P chips and foreign-listed Chinese companies. But the A shares are the big tent in the center of the fair. They are the stocks listed and traded in Shanghai and Shenzhen stock exchanges and denominated in RMB.
The A-shares market is no longer operationally difficult for foreigners. It is also quite different in make-up from other markets, for example the offshore H-share market. The H shares are dominated by the largest state-owned companies (SOEs) including the banks, energy and telecom companies, whereas the A shares include virtually the entirety of the consumer, health care and industrial sectors.
This A-shares market is, as the report says, “too big to ignore.” The space consists of 3,500 listed companies, and at the end of 2018 the market cap for it was more than $8 trillion. The companies come from each of the 11 GICS sectors.
Opportunities for Quants
Neuberger believes the A shares constitute a promising hunting ground for alpha-seeking quants. As regards the necessary infrastructure for quantitative portfolio management, it is all in place: high-quality price and trade-volume data, fundamental data, analysts’ forecast data, etc., as well as, increasingly, non-traditional, unstructured “big data” are also increasingly accessible.
Given the zero-sum nature of the search for alpha, it is good news for quants that Chinese equities receive the attention of a lot of “poorly informed, trigger-happy retail investors who leave 90% of the market’s profit on the table.” This leaves much for quant managers to harvest.
Let us return to those three factors that perform well in China, despite not performing all that well in the U.S.: size, value, and reversal. By standard definition, the “size” factor is the tendency of small issuers to outperform the large ones; “value” is the tendency of issuers trading below a fundamental valuation to do better than those trading above it; essentially a “reversion to the mean” play. Finally, and similarly, “reversal” is the tendency of stocks that have underperformed in the past month or week to earn positive abnormal returns, and for those that have overperformed to suffer losses.
Investors employing these factors have done well over the last 12 months.
But those who have relied on “momentum,” betting on the continuance of existing trends (where “existing” refers to a somewhat longer time horizon than is involved in the reversal factor) have rued the day they made that decision. Indeed, the “nature and the extent of the A-shares opportunity is closely related to the knowledge gaps and biases of the investors who currently dominate this market,” and their use of the momentum factor is one of the biases of which successful quants would be taking advantage.
A Final Thought
One might ask: now that the Chinese equity markets have opened to the rest of the world, shouldn’t the utility of various factors converge? Will the US markets work more like the Chinese markets, and vice versa, over time, perhaps as clever ways are found to arb the differences?
This paper doesn’t ask that question quite that way, but it does offer an answer: “Two decades of reform and the recent inclusion of A shares in benchmark MSCI indices are likely to unlock considerable foreign institutional investor flows into this market. That evolution may change the market over time and erode some of the factor premia we have described, but the process is likely to take a long time.”