Factor Investing Made in China

Harvesting Factor Returns in the Middle Kingdom

December 2018. Reading Time: 10 Minutes. Author: Nicolas Rabener.

SUMMARY

  • Common equity factors generated attractive risk-adjusted returns in the Chinese stock market
  • Factor performance in China often mirrors global factor performance
  • Indicates common factor drivers that permeate even emerging and isolated markets

INTRODUCTION

Economic news like changes in GDP growth are frequently used by financial commentators to explain the daily ups and downs of the stock market. However, research by Dimson et al (2002) revealed that there is a modest negative correlation between long-run equity returns and economic growth by analysing multiple countries over a century. China is a prime example of this unusual relationship as the economy has been growing at a steady 7% per annum in recent years while its stock market had anything but a steady performance.

Until recently investors were fortunate enough to be able to ignore Chinese stocks as these had a low weight in global benchmarks. However, in 2018 MSCI increased the number of Chinese A shares in its global emerging market index, which is followed by $1.6 trillion of assets. Although Chinese stocks still have a relatively low weight in global benchmarks, emerging market investors are forced to spend more time analysing these stocks and contemplate what kind of strategies work in the Chinese stock market. In this short research note, we will investigate applying classic factor investing strategies to Chinese stocks.

METHODOLOGY

We focus on all A shares traded in Chinese stock markets in the period from 2008 to 2018. The factor performance is calculated by constructing long-short beta-neutral portfolios of the top and bottom 10% of stocks ranked by the factor definitions. Only stocks with a minimum market capitalization of $1 billion are included. Portfolios are rebalanced monthly and each transaction incurs costs of 10 basis points. It is worth noting that there are few data points available for historical transaction costs for Chinese stocks.

THE NON-PERFORMING CHINESE STOCK MARKET 

The Chinese stock market comprised of A shares, which are companies from mainland China that are traded in Shanghai and Shenzhen, has not been attractive for investors in the last two decades. There have been two major boom and bust cycles since 2000, which featured drawdowns of lar