Lazard Perspectives

China A-Shares: An Opportunity in Strategic ExposureThe opening of the China A-share market to foreign investors is one of the most significant developments to impact the composition of the global equity markets in decades. Global investors are now able to access one of the most liquid and diverse markets in the world. We believe the implications for the structure of global portfolios are profound and require the attention of emerging markets and global equity investors. China A-shares are projected to exceed 40% of the major emerging markets benchmarks in the coming years, making a separate, dedicated allocation to China worthy of consideration for tactical and strategic reasons.

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Chinese Equities: Deep Roots, but a Recent FloweringThe roots of equity trading in China date back more than 150 years (Exhibit 1). The ability to trade in local shares began in 2002, when Qualified Foreign Institutional Investors (QFII) were allowed to invest with certain restrictions, including repatriation and a maximum quota (currently $100 billion) for the entire group. The advent of Stock Connect through the Shanghai Stock Exchange (SSE) and the Shenzhen Stock Exchange (SZSE) in 2014 greatly expanded the ability of international investors to access local shares.

Exhibit 1China Stock Markets through History

Date Event

1866 China shares begin trading.

1891 Shanghai Shareholders Association established.

1941 Trading suspended due to Sino-Japanese War.

1946 Trading resumes.

1949 People’s Republic of China is founded.

1984 Company stock begins trading in Shanghai.

1990 Shanghai Stock Exchange re-opens. Shenzhen stock exchange opens.

2001–2005 Stock market drops 50%. SOE equity begins conversion to local shares.

2003 QFII investors allowed to invest in China market.

2007–2008 China market collapses nearly 65%. Speculation raises volume to second-highest in the world.

2014 Exchanges open Shanghai-Hong Kong Connect, offering investors easier access to the market.

2016 Shenzhen-Hong Kong Connect opens.

2018 MSCI includes 222 China A-share companies in the MSCI Emerging Markets Index.

2019 MSCI raises additional China A-share companies’ inclusion factor from 5% to 20% in the MSCI Emerging Markets Index.

Source: Lazard

Despite being the world’s second-largest economy, China still accounts for less than 5% of the global equity benchmarks (Exhibit 2). The weights of China A-shares will undoubtedly rise significantly in the coming years as the benchmarks adjust to the capitalization implicit in this market. In addition, China’s ongoing market reforms are designed to increase foreign investment going forward.

Exhibit 2China: An Economic Giant but an Index Pygmy

World GDP versus Market Capª

(%)

0

20

40

60

ChinaJapanUS

GDPMSCI

As of 31 March 2018

a MSCI All Country World IndexSource: Bank for International Settlements

China A-Share MarketThe China A-share market contains more than 3,500 stocks. It is well diversified across sectors and industries, offering exposure to companies that can only be obtained in this market. In contrast, most institutional investment has been confined to China H-shares and depository receipts, which are traded offshore. The composition of this universe is heavily skewed to the communication services and financials sectors.

There is also considerable stock-specific concentration. Alibaba (14%) and Tencent (15%) together make up nearly 30% of the current MSCI China benchmark.1 Opening up the additional SSE and SZSE universes to investors greatly raises the number of securities available for purchase and increases the diversity of the universe (Exhibit 3). By moving beyond China H-shares, the investor can gain meaningful exposure to the consumer staples, technology, and industrials sectors, areas that, in our view, should profit from continued Chinese economic growth.

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Exhibit 3China A-Shares Offer More Diversified China Exposure

MSCI China Equity Sector Weights

Industrials

3% Consumer Staples3% Information Technology

Consumer Discretionary

3% Health Care

CommunicationServices

Energy

3% Utilities

Real Estate

2% Materials

Information Technology

Consumer Staples

Financials

Materials

Industrials

2% Communication Services

2% Energy

2% Utilities

Consumer Discretionary

Health Care

Real Estate

29%

12%

12%9% 12%

8%

7%

5%

Financials23%

24%

4%

6%

5%

24%

China A-Share Equity Sector Weights

Industrials

3% Consumer Staples3% Information Technology

Consumer Discretionary

3% Health Care

CommunicationServices

Energy

3% Utilities

Real Estate

2% Materials

Information Technology

Consumer Staples

Financials

Materials

Industrials

2% Communication Services

2% Energy

2% Utilities

Consumer Discretionary

Health Care

Real Estate

29%

12%

12%9% 12%

8%

7%

5%

Financials23%

24%

4%

6%

5%

24%

As of 28 June 2019Source: MSCI

Of course, investors in China mostly seek to directly participate in the growth of its economy, and specifically its burgeoning middle class (Exhibit 4). The A-share market provides more domestic focus, and the companies’ topline growth is likely to be driven more by the local economy than global growth. As a result, these companies have generally had a lower sensitivity to wider geopolitical issues.

Equally important, in our view, there is considerable cross-sectional dispersion in valuations compared to other broad indices, including the MSCI Emerging Markets Index (Exhibit 5). The flatter distribution indicates that pricing is likely not as efficient as in other markets. This may be driven in part by the large percentage of retail investors that dominate the Chinese A-share market.

Exhibit 4China’s Middle Class Is Growing Larger and Wealthier

Projections of China’s Urban Households by Income Groups

(millions)

Lower Middle IncomeLow Income Middle Income

Affluent

0

80

160

240

320

2030E2025E2020E20152013

As of 14 May 2015

Source: ANZ Research

The inefficiencies implied in this valuation disparity have the potential to be a significant opportunity for systematic processes. We believe they can methodically exploit the pricing anomalies. While the market will grow more efficient as the market opens up, in our view, current investors could benefit as institutional investors may act as a catalyst to correct pricing. The ability to identify and capture the opportunity set within the context of well-diversified portfolios implies a favorable tradeoff between risk and return and a more consistent pattern of excess return (represented by a relatively high information ratio).

Exhibit 5Flatter Distributions of Valuations Could Be an Opportunity

Distribution of P/E China A-Shares versus Emerging Markets

(%)

0

10

20

30

40

0–55–1010–1515–2020–3030–4040–5050–100>100

China A-SharesEmerging Markets

As of 30 June 2019

China A-Shares = MSCI China A-Share Index Emerging Markets = MSCI Emerging Markets Index

Source: Lazard, MSCI

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RisksWhile we are bullish on the opportunity set afforded to investors in the China A-share market, there are structural and geopolitical risks. We see these as principally being:

• State-owned enterprises (SOEs)

• Shareholder rights

• Operational complexity

• Government intervention

Shareholder rights remain an ongoing risk for emerging markets investors and China is no exception. While there is little legal precedent upholding shareholder challenges, the lack of voting rights is clearly a risk for China A-share investors. Activist investors have enjoyed little success in petitioning for additional shareholder privileges.

SOEs still constitute a meaningful percentage of China A-shares, which may lead to a conflict between shareholder and government interests. While valuations typically adjust for this risk, investors clearly should be aware of this and other structural differences that represent risks for investors.

Not unlike other emerging markets countries, opening a custody account in China is a complex process and investors unwilling to invest in a pooled vehicle must be prepared for some delay and administrative paperwork. Investors also have to deal with different settlement cycles, which become more challenging if one is dealing across regions. Holidays also close the markets for extended periods, which should be factored in trading—especially across countries and regions.

While we believe the potential of government intervention in the market is low, it remains a potential risk for foreign investors. The Chinese government has actively supported the opening of their markets to outside investors, recognizing the benefits of outside capital to fuel their economic growth. The potential repercussions of a policy reversal and government intervention would be severe for China and their access to outside capital for decades.

These risks, in our view, are manageable, but they do increase the need for an active manager to help navigate the unique characteristics of this market.

China A-Shares: A Strategic Allocation The China A-share market and its long-term investment potential should attract the attention of any global investor. Whether investors allocate separately to this market or wait for rising index inclusion, China A-shares should not be ignored. Given the country’s economic prominence and global scale, we would argue that investors should consider a long-term, distinct allocation to the market. The market is prone to less efficiency and greater valuation extremes. A dedicated exposure will help take advantage of the current opportunity set and, with a disciplined rebalancing methodology, capture the ongoing mispricing opportunities that may occur.

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LR32210

Notes1 Source: MSCI, as of 31 March 2019

Important InformationPublished on 1 October 2019.

This document reflects the views of Lazard Asset Management LLC or its affiliates (“Lazard”) based upon information believed to be reliable as of __ September 2019. There is no guarantee that any forecast or opinion will be realized. This document is provided by Lazard Asset Management LLC or its affiliates (“Lazard”) for informational purposes only. Nothing herein constitutes investment advice or a recommendation relating to any security, commodity, derivative, investment management service or investment product. Investments in securities, derivatives, and com-modities involve risk, will fluctuate in price, and may result in losses. Certain assets held in Lazard’s investment portfolios, in particular alternative investment portfolios, can involve high degrees of risk and volatility when compared to other assets. Similarly, certain assets held in Lazard’s investment portfolios may trade in less liquid or efficient markets, which can affect investment per-formance. Past performance does not guarantee future results. The views expressed herein are subject to change, and may differ from the views of other Lazard investment professionals.

Equity securities will fluctuate in price; the value of your investment will thus fluctuate, and this may result in a loss. Securities in certain non-domestic countries may be less liquid, more volatile, and less subject to governmental supervision than in one’s home market. The values of these securities may be affected by changes in currency rates, application of a country’s specific tax laws, changes in government administration, and economic and monetary policy. Emerging markets securities carry special risks, such as less developed or less efficient trading markets, a lack of company information, and differing auditing and legal standards. The securities markets of emerging markets countries can be extremely volatile; performance can also be influenced by political, social, and economic factors affecting companies in these countries.

Certain information included herein is derived by Lazard in part from an MSCI index or indices (the “Index Data”). However, MSCI has not reviewed this product or report, and does not endorse or express any opinion regarding this product or report or any analysis or other information contained herein or the author or source of any such information or analysis. MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any Index Data or data derived therefrom.

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About the TeamThe Lazard Equity Advantage team believes that core exposure is best maintained through a systematic approach that avoids overweights to styles, sectors, or industries in relation to the benchmark. Using a proprietary investment process, the team selects companies that it believes offer attractive fundamentals and high-quality financial characteristics.

The team joined Lazard in 2008, and today it manages a range of benchmark-aware global and regional systematic equity strategies and low-risk global equity strategies. The team consists of 11 investment professionals with more than 21 years of industry experience, on average. As part of their process, they draw upon Lazard’s global research platform and they benefit from the firm’s infrastructure, which includes risk management and operations support.