The case for China securities inclusion in your portfolio
Summary
China is still underrepresented in the most important world indexes, China’s GDP compared to the World is 18% in 2021, China weight in MSCI ACWI index is 3%, yes only 3%.
U.S. Finance media take China financial markets with the same lens they see U.S. financial markets, their focus in U.S. has been Growth companies, therefore they investigate the China technology sector when real growth there comes from discretionary consumption drove by a large new middle-class population.
The source of value for existing portfolios is from the low correlation of China financial market against the typical 60/40 portfolio and versus other Emerging Markets and Non-U.S. developed markets.
Regulation is a valid concern, different legal and political frameworks create confusion but going back to the maturity of the market, China financial market is young and facing normal growing pains. China is trying to be seen as a stable and robust financial market to be able to compete and attract businesses and consolidate a more relevant geopolitical role.
Finally, investing in China to capture the benefits of its growth must be targeted to China inland “value sectors” opportunities and not in the technology sector that mirror U.S. market, or any other ADR not publicly trade in China, correlation matters!
Overview
There are technical reasons why key world market indices does not properly weight China, however, at this point we only can expect an increase in its weight given the size it has reached and the large turnover that is present in the exchanges at Shanghai, Shenzhen, and the Hong Kong Exchange.
This higher expected weight in the world indices will force institutional investors to follow suit and increase their positions in China to be able to track their benchmarks increasing the demand in China assets. This will be a positive outcome for earlier investors.
China having 18% of World GDP and 21% of global equity market capitalization the MSCI ACWI index only distribute to China 3%
But how to invest in China?
Talking about investing in China is confusing because of the existence of several types of shares in different exchanges. Here I am going to mentioned just the more common ones:
first, we have ADRs, these are Chinese securities listed on NYSE or NASDAQ and are traded in USD
we also have share class “A”, Chinese securities listed on Shanghai or Shenzhen stock exchange and are traded in RMB
finally, share class “B”, these Chinese securities are listed on the Hong Kong stock exchange and are trade in HKD.
The list is no exhaustive and it is important to note that some Chinese ADR’s may not be listed in China at all.
The best-known names in the U.S. are Alibaba (BABA) or Tencent (TCEHY). Most of the biggest ADRs from China are in the tech sector and follow closely with their U.S counterparts in terms of risk profile.
As an investor you could position yourself directly into specific securities or take exposure using ETFs focus on China assets.
Correlation Matters
Having already a common portfolio usually means have a large exposition to S&P500 where its main component in the last few years has been tech stocks, therefore, adding Chinese ADR’s is adding more of the same exposure you currently have.
Remember, that the idea of a portfolio is to have a broad based of assets with low or negative correlations among them, the goal is to add a mix of assets that when one goes down the other goes up, so your focus is to add “different” type of assets not more of the same.
This in practical terms implies that the type of Chinese securities you should add are outside the tech sector, because they have a different risk/return profile.
China’s A shares has a correlation with the world market at 0.21 vs U.S which has a 0.9, the lower the number the higher the potential diversification value. Worth noting that Hong Kong shares has a correlation of 0.38 as it has a composition of shares and sectors more like the U.S. financial market and if only Chinese ADR’s shares are considered the correlation jumps even higher.
In contrast European equities and Emerging market equities have a correlation of 0.79 and 0.66, respectively
China’s A shares in a diversified portfolio will add excess return and reduced total risk.
Risks
The Chinese equity market is a young initiative for China and for the international investors, the market is far to have the maturity of the U.S. financial market, this is a risk but at the same time a true opportunity, as the market cannot be considered efficient and therefore excess returns (alpha) could be obtained.
Political and legal risk also exists, and a wave of control and change in the legal framework has occurred in the recent past, however, the Chinese want to take a more relevant geopolitical role and ensuring a stable business framework is a top priority. There is an increase employee participation into the ownership of companies listed in the market which creates some incentives to avoid inducing harm to the market as Chinese citizen will suffer.
Accounting differences is also a factor to take into consideration at the moment of analyzing Chinese companies with U.S. lenses.
In the U.S. financial markets, the trading activity is dominated by large institutions, basically trading among themselves, for a small shop or small retail investors thinking that they could win in a transaction against the giants is difficult and rare, however, in China the retail participation is close to 85%, which creates an opportunity as it could be easily argue that no financial professionals and institutions has taken over yet the market.
What is next?
Keep a well-diversified portfolio, ensure you have exposure to different assets across the globe, today this is easier than ever, and this is true too for the Chinese A-shares. Before you take any action assess your portfolio, risk, suitability to your investment goals and remember investment is a long-term game.
The sooner you take exposure to the Chinese market the better, as this market develop and grow it will move closer in its behavior and structure to the U.S. market and the correlation will increase reducing the current diversification value.
For more help, please feel free to reach to me,
Jose M. Manstretta, CFA
Portfolio Manager
Open Wealth Management, LLC
Cell: +1 504 952 0724
jmanstretta@openwealth.us
Q1-2022 Where are we? Where are we going to?
As of the end of Q1-2022, we had experienced a lot of the fears coming into 2022 and much more, at the end of 2021, we were talking about OMICRON variant, inflation, and interest rates hikes. In Q1-2022 we faced Russia-Ukraine war, a surprised acceleration in inflation and a FED increasing 25bps the interest rate and setting the expectation for future rates hikes during this year. Not all news is bad, labor market continues to be tight. One thing is to suffer inflation and high unemployment and other is to face inflation and tons of works options, by no means I want to underplay the situation, but it could be worse.
During Q1-2002 S&P500 dropped 3.6% and NASDAQ 5.8%, January and February were RED months, however, after the FED raises interest rates the market started to recover, and March was a GREEN month. My view is that the market was more nervous about a potential policy mistake than anything else, the FED has a tough job. Their objective is to balance employment and inflation and that is a hard trade-off, a mistake here could cause a recession later in 2023 or create the conditions for moderate economic growth despite the increase in the monetary base in 2020 and 2021.
As I write this update, 30-year mortgage rates are at 5% level and at the same time the average house cost has increased as much as 25% in some areas. This translates in doubling of mortgage payments for new home buyers in 2022 vs 2021. If it were not for the inflation and the tight labor market, I would expect a plunge in home prices this year.
We should not forget that bad economic times are bad for everyone, it is bad for politicians, it is bad for corporate America, it is bad for all citizens. I want to stress that given this fact, everyone is trying to ensure we do not enter into a recession, we must remember the recent enacted infrastructure bill, where increasing funds are going to be allocated to recover and improve the national public infrastructure. This could be a potential safeguard for the economy, and this is just an example of politicians trying to help the system. I am a cautionary optimistic about 2022.
Economic cycle is not synchronized with the market cycle. Emotions plays a significant role in the market cycle and are sensible to the news cycle, market could have already absorbed the war, the interest rate hikes and a potential slow economic growth, the short-term will continue be volatile.
What options do we have? The bad options are clear! if you do nothing and stay fully in cash you will lose to inflation 5%-7% this year, if you add the 7% inflation from 2021, this translates into a loss of ~12-14% in 2 years. If we try to move to fixed income, even in high quality and short duration the inflation and the announced interest rates hikes will damage your capital.
The option is the stock market which has prove to be a good inflation hedge historically. The equities sector is huge, and we need to properly allocate funds to replace temporary the fixed income asset class with low Beta stocks (stocks that move less than the market) and pays steady dividends and avoid stocks with high P/E ratios which value usually comes from long term or even terminal cash flows.
Our portfolios are set to do that and to keep a small exposure to economic areas where innovation could result in disproportional growth.
Finally, I want to add that great companies sometimes are not good investments due to its high price, great investments and returns come from finding companies that are price cheap!, we are in the downturn of a growth cycle and opportunities could arise any day now to jump back into growth names, and potentially at the end of the year into fixed income again which dictates the need to keep a cash reserve for it.
Jose M. Manstretta, CFA
Chief Investment Officer
Open Wealth Management, LLC
Cell: +1 504 952 0724
Investor’s Letter November 2021
At this point of the year the S&P is up 25.3%, now with most of the turbulence cause by COVID-19 and CARES act behind us, the market is starting to calibrate its early impact expectations vs its real impact in the economy. This will translate in volatility and unreasonable overreaction to minor news. For long-term play opportunities, we could see sudden interesting entry-points in the Tech Sector, however, be careful as not all Tech Sector is equal, at this time Tech Companies with positive track record in the earnings are the ones to look for, although overall Tech sector is the place to overweight your portfolio, the non-earnings companies has their value coming from future cash flows subject to inflation and interest rates, the cash flows are more likely than not to be real but its value today for the investors vs current companies printing cash makes them less attractive.
My investment thesis hasn’t change for your portfolio, we have a diversified portfolio set to navigate in a high inflation economy with global exposure to growth. Long-term real total return with downside protection is what I’m looking for with our portfolio, it’s important to note the components of this equation, dividend yield, interest income and capital growth net of US inflation, having this in mind, I want to highlight that S&P500 is a highly concentrate index, not representing a true comparable to a well-diversified portfolio, Microsoft, Apple, Meta, Tesla, Nvidia and Google makes around 25% of the index at today prices.
A couple of final reflections:
a) the 2021 inflation as an outlier in the last decade will force us to be more precise when we compare 2021 portfolio returns vs previous years as an example a 20% return in 2021 is not the same than a 20% return in 2019 due to the magnitude in the inflation difference, in 2019 the US CPI was 2.3%, making a nominal 20% return into a 17.7% real return, for 2021 the 12mo. inflation as of October is 6.2% making a 20% nominal return into a 13.8%, as you can see in the surface 20% return in 2021 and 2019 are very different (13.8% vs 17.7%)
b) Equity market valuations continue to seem expensive in absolutely value judge by current P/E levels, however, it is an attractive place in relative terms, the investor alternative is to be in the bond market which with this changing expectation in the level of rates makes the search for yield in the equity market a no-brainer, however, this could change once inflation recede to normal level and a potential new regime in interest rate appears, all this is highly dependent in the real economy growth and in the public policy space, the current FED Chairman Jerome Powell has been renominated for a second 4 year term at the front seat of the Federal Reserve, this could indicate a continuation of the current policy, will see.
In a next note I will laid out what could be the potential tactical actions for 2022.
Jose M. Manstretta, CFA
Chief Investment Officer
Open Wealth Management, LLC
Cell: +1 504 952 074
Q2 2021 Market View and Investment Portfolio
COVID-19 and its new variants has triggered a shock-wave in the way we live our life, consume and engage with others; this change in Individual behaviors at micro-level is dictating how big companies are starting to make business, interact with other industries and changing old supply-chains. This is an expected change that was in progress “before-COVID” and has been accelerated some 5 years because of it. The prime-time of new technologies like AI, new communication infrastructure and cloud services together with 5G has allowed to permeate and facilitate application cases in every industry, we can see for example in the O&G services how Schlumberger is launching “autonomous directional drilling” a giant leap in a routinary activity.
The US Government and the Federal Reserve support to protect the population and the financial market this triggered an increase in the inflation rates. There is no agreement about how long could these level of rates go-on. At the same time Biden’s new infrastructure bill is being discussed to have a lasting impact in the medium-term GDP growth, the outcome in the GDP and Inflation rates between the cease of the COVID response and the Infrastructure bill is not yet clear.
In an unexpected move China government took actions to control their shining stars in the technology sector.
Corporate Board and Shareholders activism is pushing an agenda where ESG is vital to compete and continue in business, the one and mighty Energy sector is being shake in its core, Exxon board of directors was recently reshaped. A District court in The Hague is pushing Royal Dutch Shell to reduce its net carbon emissions. Facebook, Amazon, Google and Apple are under constant regulatory pressures due to their market power and data/privacy practices.
E-gaming industry, Social and Gaming metaverse seems to be taking new business models and reaching to larger communities. Tomorrow’s economy will be different!
This is the moment for Active Portfolio Management to set different allocations to gain exposure to non-traditional leaders. An opportunity to look closer to “mature business” and see how they are deploying financial and human resources to bring new smart technologies to their businesses and survive in a new environment, this players could be a hidden-gem as they have deep pockets to deploy new tech in their business processes.
At the same time, it is a moment to evaluate how Inflation will impact short-to-medium term portfolios returns.
There is no doubt that in the long-term having exposure to the market will protect and generate some wealth, but it is imperative a proper mix of assets classes, sector selection and a controlled country exposure could potentially limit downside risk and create additional returns over the market.
Jose Manstretta, CFA
August 23, 2021
Houston economy is all about Oil and Gas (O&G) and related services companies and it has been the case for decades, this has allowed to bring significant human capital from all the world. O&G growth and deep technical talent drove great remuneration, but what has all this to do with portfolio allocation and COVID-19?
A common pitfall in portfolio construction is not to take into consideration all the assets of the
investors and one of the most important assets that people has its their own human capital, their ability to generate income and how that income correlates to their “normal” investment portfolio.
Individual investors tend to put their money in areas they are familiar with (Illusion of control, overconfidence and availability are some the behavioral biases present in this situation), Houstonians, O&G workers and executives tend to overinvestment in the energy sector, their professional remuneration packages are link also to the energy sector and this usually exacerbates as they progress in the corporate ladder and their variable component in the remuneration grows.
COVID-19 has destroyed the oil demand, with that the O&G sector has downsize, O&G equities has dropped more than 50%, hundreds of small companies in the sector have defaulted, this scenario has shown to individual investors in Houston how bad their portfolio allocation has been, the correlation between their human capital and their portfolio is positive and close, now hundreds of O&G executives are losing their jobs and at the same time are seeing their investment portfolio loss value.
Human Capital needs to be part of the portfolio allocation process, this should be a cautionary tale
to the people working in the technology sector, today they are driving more and more economic growth and attracting talent with proliferation of restricted stocks options makes a perfect scenario to overlook in their individual portfolio allocation their HUMAN CAPITAL and its correlation with their personal investments. Lookup and try to identify if you are failing in the common behavioral biases error when you compare what you do, where do you work and where have you invested. Do not wait to happen to you.
Jose Manstretta, CFA
January
10, 2021