A common misconception is to underweight Asian equities in UK asset allocator’s model

As a former portfolio manager of multi-asset, multi-manager funds in the UK who was born and raised in China, I’ve been working in relations with Asia throughout my career. I’ve found that the majority of asset allocators here in the UK still attribute a relatively small weight to Asian equities. Even in the most aggressive asset allocation models, it is not uncommon to see Asian exposure limited to a single digit percentage, which is mainly expressed through equities alone rather than bonds or a combination. The highest allocation to Asian equities together with EM equities all combined, could be up to 20% in the equity risk model of the bravest asset allocators, but it remains rare.    

I see two key reasons for this: 1) Strong “home bias”. Most peers in the industry still prefer to preserve their primary equity allocation for US equities or Global equities, followed by UK equities due to their clients’ preferences and familiarity with these developed countries. 2) “Herding bias”. Many asset allocators are still using the MSCI World or the MSCI ACWI as the starting point for considering their structural asset allocations. Although China represents close to 50% in the MSCI Asia ex Japan index, its exposure is still limited to less than 5% in the MSCI ACWI index. This is quite modest despite China’s ever increasing contribution to global GDP growth over the last decade. The Asian country accounted for 28% of all growth worldwide in the five years from 2013 to 2018, more than twice the share of the United States, according to the International Monetary Fund, and yet the US continues to remain the largest allocation in the MSCI ACWI index (> 57%). This is partly due to allocators using backward looking MSCI indices rather than forward looking growth.

Obviously the Cov-19 crisis has called previous growth trajectories into question, and we’ll review these once we have more clarity when the world enters the “new normal”. But it happens that the Chinese A shares were one of the best performing equity markets in the world ytd (to July 2020) compared with other major developed market equity indices with much lower drawdowns in March.  Whether this was to do with the quicker re-opening of the Chinese economy or Chinese State funds supported the Chinese domestic stock market, the Chinese A shares demonstrated a strong decorrelation with other developed equity markets.

When it comes to the main concerns of investors, the reasons we’ve often heard for not allocating more capital to Asia are: 1) Volatility risk; 2) Currency risk; 3) Chinese debt concerns – “hard landing” scenario. The recent retaliation measures between US and China, the two biggest economic powers, may well trigger a new “cold war”, which could provide a perfect storm for some to tactically reduce exposure to Asia again. But the question is to what extent can you cut exposure to Asia if you already have single-digit exposure.

First of all, I personally don’t think volatility alone should be used as a measure for risk. Secondly on a forward-looking basis, if you embed the current valuations into the expected returns over the medium term, then Asian ex Japan equities alongside UK equities would probably be among the most attractive asset classes besides EM Local Currency debt on the risk-adjusted basis. With regards to Chinese debt problems, the Chinese government has made considerable efforts over recent years to de-leverage the balance sheet of SOEs, reduce the overcapacity of traditional industrial sectors and tackle the shadow banking system of state-owned banks. The “hard landing”, which used to be a hot debate among investors a few years ago, is less of a concern these days, as latterly investors move on to worry about the US-China trade wars, and going forward perhaps the new “cold war” era between the two nations…

I believe that asset allocators in the UK are significantly underestimating the economic growth potential in Asia, notably China and India, as their economic impacts are far less represented by their inclusion in the MSCI index. There are ways to avoid being exposed to the “old economy” and SOEs when it comes to investing in China as corporate governance and protection of minority shareholders’ rights are high on investors’ agendas. According to a working paper of the World Economic Forum in 2019, the private sector has been the driving force of China’s economic growth, “The combination of numbers 60/70/80/90 are frequently used to describe the private sector’s contribution to the Chinese economy: they contribute 60% of China’s GDP, and are responsible for 70% of innovation, 80% of urban employment and provide 90% of new jobs.” China has effectively shifted its economic model from being export-led to domestic consumption and innovation-driven.

Last but not least, the China A shares market represented merely 3% in the MSCI EM index by December 2019. A shares exposure is being gradually increased in the MSCI index, such that if 100% of China A shares were included in the MSCI index, it would represent around 15% of the MSCI EM index. This means that existing investors with allocation to active managers in the region could potentially benefit from a combination of alpha and beta effects when passive funds start to reflect the increasing inclusion of A shares in the MSCI EM index.

I think asset allocators should increase their exposure to China / Asian equities in their long-term structural asset allocation model ahead of the curve from the (low) single digit exposure to a more appropriate allocation depending on the return target and risk tolerance of their mandates.