Integrating smart beta into a developing Chinese market

Jason Hsu, adviser to Premia Partners – also founder, chairman and chief investment officer of Rayliant Global Advisors, and co-founder and vice chairman of Research Affiliates – and Aleksey Mironenko, partner and chief distribution officer, discuss how Premia Partners and Rayliant Global Advisors are positioned to address product gaps and devise solutions for deploying smart beta strategies into the Asian – and particularly Chinese – market, and how investors can seek ways to improve their exposures

When was smart beta first deployed in China?

Jason Hsu

Jason Hsu: The first smart beta index in China was the China Securities Index Company’s Research Affiliates Fundamental Index (CSI RAFI), which launched in 2009 – a collaboration between the CSI and Rayliant Global Advisors (formerly Research Affiliates Asia). The first exchange-traded fund (ETF) product based on CSI RAFI was launched by Harvest Funds in China in 2010.

 

What are the differences between applying smart beta to a developed market and applying it to a developing market?

Jason Hsu: Generally speaking, smart beta strategies work better in less efficient markets, thus we expect stronger outperformance from smart betas designed for developing markets. There are definite reasons to adopt different smart beta constructions for developing markets – for example, many are dominated by state-owned enterprises (SOEs). You need to take that into consideration, otherwise your value smart beta will be dominated by SOEs, which tend to trade at low price/earnings and price/book ratios, but do not necessarily generate a value premium.

 

Do the factors used in the US and Europe work in China?

Aleksey Mironenko

Aleksey Mironenko: Yes and no. Many of the well-studied factors in developed markets perform well in China – value, low volatility and size all show excess return. That said, simple replication of US signals leaves a lot of excess return on the table as there are nuances specific to China that can improve the outcome. Dividends are a great example – normally a reliable indicator of value, the signal simply does not work in China because of local regulations. This is why we are working with Rayliant on our China smart beta products – its research ensures the strategies are fit for purpose, and not just copy-and-pasted from the US.

 

How much interest has there been in smart beta strategies in China?

Jason Hsu: China is a ‘fast follower’ when it comes to smart beta. The global success of smart beta products has generated a buzz and a demand for products. However, for smart beta to really gather assets under management – and to make a meaningful difference to Chinese (retail) investors – the products may be better incorporated into fund-of-funds or multi-strategy products for diversification, or in ETF form for flexibility compared with outright long-only mutual funds.

Aleksey Mironenko: For global investors, the current approach is to use either a traditional beta ETF or an active fund. The popular ETF benchmarks (FTSE A50 and CSI 300) leave a lot to be desired – the top 50 or 300 stocks by market cap result in large financial or SOE weights without other considerations and are not representative of China’s economy. With MSCI inclusion and more channels opening up, investors are realising that the expedient approach is not always the right one, which is where smart beta comes in.

 

What should investors consider when looking at smart beta?

Jason Hsu: Investors should understand that smart beta products are tools rather than solutions. They will need to buy a diversified portfolio of equity smart betas as well as non-equity strategies to construct the right solutions. For Chinese investors, the desired solution is often absolute return or downside risk-controlled by nature. No single smart beta product could deliver on that outcome and, in such circumstances, a multi-factor fundamental approach would be more appropriate than taking a concentrated bet on any single factor that may fall out of fashion or become too expensive because of crowding. 

Aleksey Mironenko: What works for one investor in smart beta may not work for another. China is a two-speed economy – some investors prefer new economy tilts, others prefer the mainstream companies, while many actively allocate between the two. While smart beta is a key consideration, it’s also important to ensure asset allocation fit. For example, if an investor is unhappy with the FTSE A50 financials allocation, a smart beta tilt of the same universe will not resolve the real issue.

 

How should an investor distinguish among smart beta strategies?

Jason Hsu: There are two major categories of smart beta: single-factor and multi-factor – and this is not specific to China. The popular single-factor smart betas are value, low volatility, small cap, quality and momentum. Generally, for investors looking to dynamically allocate to different exposures, the single-factor smart beta is the appropriate tool. In the multi-factor space, there is an abundance of varieties, among the most popular of which are theme-based multi-factor smart betas, such as the recently launched CSI Caixin Bedrock Economy Index and the CSI Caixin New Economic Engine Index. These indexes select stocks based on a particular investment theme, then weight them by their respective factor scores to generate excess returns.

 

Tell us more about theme-based multi-factor strategies.

Aleksey Mironenko: The two strategies look to solve the two-speed economy dilemma investors face in China. The Bedrock strategy is a core economy approach – it targets the largest stocks and contributors to GDP today. The New Economy strategy utilises the Mastercard Caixin BBD China New Economy Index to define sector exposure. While the Bedrock approach leans heavily on financials, industrials, real estate, and so on, the New Economy approach targets consumer discretionary, technology and healthcare – financials are close to zero. These two options allow investors to express a view on different portions of the economy. Once the universe is decided, the benchmarks amplify those factor exposures that generate excess returns in China. For Bedrock, that’s value, quality, low volatility and size, adjusted for China where needed. For New Economy, the focus is instead on low fixed assets, quality, productive growth and liquidity. The goal is to capture the excess return available in their respective universes. The results speak for themselves, with Bedrock generating ~8% excess return annualised versus CSI 300 since 2005.

 

Is there any evidence of smart beta’s success for China beyond these new strategies?

Jason Hsu: The nine CSI RAFI indexes launched since 2009 have averaged 3–5% outperformance versus their respective cap-weighted indexes. This is probably the best real-world data supporting the efficacy of smart beta’s application to Chinese stocks.

 

Many investors believe that active is the only way to access inefficient markets such as China. How do you know this approach will work?

Aleksey Mironenko: Inefficient markets create alpha opportunities, which can be captured by smart beta strategies as well as active managers. Fundamental bottom-up research originated in the US, yet we all accept that it works in emerging markets when adjusted correctly, given the inefficiencies involved. The same is true for smart beta: inefficient markets amplify signal strength. This is why RAFI in China averages 3–5% outperformance, while in the US the same approach only yields 1–2%. Similarly, multi-factor strategies in the US typically deliver low single-digit excess returns, whereas we see high single digits with Bedrock. The key is not to replicate blindly, but to adjust for specific markets and ensure the smart beta is fit for purpose.

 

Why are there fewer smart beta funds available to invest in developing markets?

Jason Hsu: Developing markets tend to be followers when it comes to financial product adoption. Smart beta has only recently become a widely adopted investment strategy in the developed world and it is in the early stages of the adoption cycle for developing markets. On the supply side, shorter histories, data cleanliness and a lack of commercial product availability are areas to improve on before widespread adoption in developing markets. Rayliant is working on the first two parts and collaborating with Premia Partners to bring products to the market.

 

Where do smart beta strategies fit into an asset allocation portfolio strategy?

Jason Hsu: Smart beta strategies are often used to replace underperforming active managers or passive cap-weighted index products. It is important to realise that smart betas are not new asset classes, but ways to create excess return relative to the standard cap-weighted indexes.

 

How can investors effectively manage risk when deploying a smart beta strategy?

Jason Hsu: Generally, smart beta products are long-only – this is especially true in China because of to the no-shorting constraint. Thus, Chinese A-share smart betas will have volatility similar to the major market indexes, such as CSI 300, which has historically averaged around 33% per annum. This means there is substantial risk of large negative returns. To manage this downside risk, investors should combine their smart beta investments with other non-equity asset classes to diversify away some equity risk. Alternatively, accessing smart beta strategies through more liquid tools such as ETFs provides an added degree of flexibility and tactical adjustment.

 

Which factors are best in deploying a smart beta strategy for China?

Jason Hsu: I would certainly advise against investing in only one factor exposure – there is no evidence that one equity factor dominates other factors. The standard factors have all been vetted by academic researchers, and deliver outperformance at different points in time. Thus, the right approach is to diversify across the different standard factors.

 

How do you see the smart beta market in Asia evolving over the next two to three years?

Jason Hsu: Smart beta adoption will increase in Asia over time – similar to developed markets – as providers increase educational efforts. Institutional investors, financial technology and fund of funds will likely be the early drivers of flow into smart beta, as allocators tend to be more sophisticated in their investment knowledge. Ultimately, the success of smart beta products depends on the creation of cost-effective products and strategies that deliver on outperformance. On that front, the relatively larger expected excess return for smart beta strategies in developing markets bodes well for strong adoption.

Aleksey Mironenko: With the inclusion of China into global benchmarks, it’s only a matter of time before investors start looking for ways to improve their exposures. The same is true for Asia more broadly. Already clients are questioning the high fees in Asian active management and the lack of product granularity and variety in Asian betas. Addressing the product gaps in Asia is the primary reason we started Premia Partners. Investors will demand better solutions to Asian exposures quicker than most will expect, and our goal is to be there for them and to help fill those product gaps.

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