EQD Research: Gaining Exposure As China's Economy Expected To Rebound

The most recent IMF growth projections call for a global GDP rebound of 6.0% this year and 4.4% in 2022. Some countries are expected to experience faster growth than others and it should be no surprise that the leader will be China. The IMF’s most recent growth estimates for China are 8.4% in 2021 and 5.6% in 2022. The table below shows the most recent IMF growth estimates for major economies in 2021 and 2022.

Data Source: IMF World Economic Outlook April 2021

 

Chinese Equity Indices

Despite expected strong growth for the Chinese economy over the next couple of years, many measures of equity performance in China are underperforming. There are multiple Chinese equity indices, but only a handful have active derivative markets. Choices include the Hang Seng Index (HSI), Hang Seng Technology Index (HSTECH), Hang Seng China Enterprises Index (HSCEI), and the FTSE China 50 Index (China 50). All four have active futures markets allowing for easy access to Chinese stocks.

These four indices each offer exposure to the Chinese market, but the components of each vary greatly. The following table ranks the top three industry exposures for each of these China focused indices as of late May 2021.

Data Source: Bloomberg

The HSI is heavily weighted toward financials representing just over 40% of the market capitalization of the index. Financial stocks are also the largest representation of the HSCEI at 30% of the index with Communication Services the second most represented sector at 20%. Not surprising, the HSTECH index is most heavily weighted toward Information Technology at 35% with Communication Services the second highest weighting at 30%. The China 50 index stands out with Consumer Discretionary stocks representing 35% of the index and Financials at 30%. All of these indices with futures markets are heavily influenced by just one or two sectors. The slight performance differences through the first five months of 2021 on the chart below can be attributed to these difference exposures.

Data Sources: Bloomberg / EQDerivatives Calculations

For easy side by side comparison, each index is adjusted to start at 100 on the last day of 2020.  All of these indices rose over 10% to start out the year, with the HSTECH index topping with a gain of over 30%. Chinese stocks have given up the gains with the current year to date returns ranging from up 7.0% for the HSI to down 3.8% for HSTECH. The returns have varied, but also the volatility associated with those returns differ as well.  The next table shows the annualized realized volatility through May 2021 for each of the China focused indices,

Data Sources: Bloomberg / EQDerivatives Calculations

As noted, in 2021 HSTECH has been in a wide range and this shows up with realized volatility pushing almost 40%, much higher than the other three indices. The China 50 also has relatively high realized volatility for 2021 near 27%.

Factors To Consider

As mentioned, each of these indices has active futures markets. The three Hang Seng indices trade at the Hong Kong Exchange and SGX is home to the SGX FTSE China H50 futures. The Hang Seng indices have an initial margin requirement falling between 8.8% for the HSI to 11.8% for HSTECH. The SGX contract is much more capital efficient with an initial margin of 5.7% meaning investors can gain exposure to Chinese equities, long or short, with a lower capital requirement.

Another factor an investor should take into account is the executive order from the United States that prohibits exposure to Chinese companies deemed to be associated with the Chinese military. This ban impacts the three Hang Seng indices, but does not apply to the SGX contract as the underlying index was adjusted and will continue to be adjusted to avoid holding any of the sanctioned companies.

The FTSE China 50 index is the underlying market for several other actively traded instruments. For instance, the iShares China Large-Cap ETF (FXI) offers performance that matches the index. The average daily volume for FXI is just short of 18 million shares and the fund has almost USD 5 billion in assets under management. Also there is a very active FXI option market with average daily volume of 85,000 contracts. For more adventuresome traders, Direxion ETFs offers both a 3x bull and 3x bear ETF with the China 50 as the underlying market.  The bullish version trades with the ticker YINN and bearish one appropriately using the ticker YANG. The table below summarizes important information regarding all three ETFs.

 

Data Sources: iShares / Direxion / Bloomberg

Typically, longer term investors will shy away from futures contracts for exposure to a broad based index. Futures prices adjust for dividends and when the futures market displays a downward forward curve there is a benefit when rolling positions forward. For example, if a holder of SGX futures contracts rolled their position the day before expiration each month the result is a performance benefit of 89 basis points for the first five months of 2021. This assumes a monthly cost of 8 basis points to roll positions forward. The result is performance from the futures markets that is in line with that of the total return of the China 50 index.

Finally, on a fundamental basis there also may be reasons to favor the China 50 futures over the other contracts.  As noted at the beginning of this article, the Chinese economy is expected to experience above global growth averages for developed economies over the next couple of years. Additionally, the Chinese economy has developed into being much more consumer oriented than manufacturing. This means unlike past periods where China was experiencing strong growth, the beneficiary will be consumer focused stocks . In addition to being the most capital efficient and index with no exposure to US sanctions, the China 50 index is the most consumer focused of these four indices which is an area that will be a major beneficiary of the resumption of rapid economic growth in China.