Why It’s Time to Make a Standalone China Allocation, Willis Says

Too many investors don’t target investments to China itself and prefer to include the country in a basket of emerging market (EM) nations, which waters down what they could earn by concentrating on the world’s second largest economy, according to a Willis Towers Watson report.

Traditionally, allocators have relied on global or EM strategies to gain exposure to China, the report noted. But a dedicated China-only play could achieve even better returns and diversify portfolios, it argued.

“We believe including a standalone allocation to onshore China in the equity portfolio should lead to an improvement in long-term risk-adjusted returns,” according to the report released Monday, titled “The Merits of a Standalone Equity Allocation to China.”

Though the country is vast, when it comes to its share of the global equity markets, China may not appear at first to merit a standalone investment for some investors. While the country accounts for 16% of the world’s gross domestic product (GDP), it accounts for just 5% of the MSCI All World Index.

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Similarly, pension funds and endowments dedicate just 3% to 5% of their portfolios to China equity exposure, according to a Greenwich Associates report. Still, China strategies are expected to perform well.

Researchers in the report called this traditional perspective “backward looking,” given that on a full market capitalization basis, China currently accounts for 20% of global indexes, a measure that may be a truer reflection of the country’s growing grasp of the world’s equity markets.

Meanwhile, the report said, major index providers are also expected to hike their China investments in the next decade.

“When other countries entered such indexes, there was a marked increase in foreign participation and investment flows,” the report said. “In our mind, it is better to be positioned ahead of this trend.”

But investors who are debating expanding into China must consider this: An allocation into the China market may require an entirely different asset allocation framework, given that the state regime has a firm grip over the private sector, analysts said. It’s a point investors are unlikely to soon forget after the recent Ant Group public offering was foiled by Chinese regulators.

Other obstacles also remain: An immature market and a relative dearth of information can make stock selection difficult for investors without the resources to get on the ground and develop local insight.

It also means that allocators must be highly selective when choosing their managers. While analysts said they prefer an active investment approach to China investments, results vary greatly across managers.

Over a 10-year period, the difference between managers generating returns in the fifth percentile and the 95th percentile can be greater than 10 percentage points per year, or the difference between a 9.8% gain and a 0.6% loss.

Still, expanding into China will help diversify portfolios. A policy focus on maintaining growth through credit availability has helped China become less correlated to global markets.

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New European rules on sustainability disclosure requirements in the financial services sector take effect in March, affecting institutions such as banks, insurance companies, pension funds, and investment firms. And while details of the Sustainable Finance Disclosure Regulation (SFDR) have not been finalized, law firm Akin Gump says the move to increase requirements shows the EU and the UK have “ambitious plans” for improving environmental, social, and governance (ESG) disclosures for financial firms.

In 2018, the European Commission established an action plan on financing sustainable growth. And “Action 7” of the plan, which takes effect March 10, calls for clarifying institutional investors’ and asset managers’ ESG disclosure duties. It sets sustainability disclosure obligations for manufacturers of financial products and financial advisers in relation to the integration of sustainability risks by participants such as asset managers, pension funds, and other institutional investors.

According to Akin Gump, the three main disclosure requirements specified by the European Commission are: 1. Disclosures related to the integration of sustainability risks in the investment decisionmaking process; 2. The pre-contractual disclosure requirements applicable when products are promoted as having an ESG focus or investment objective; and 3. The disclosures related to whether an investment manager or financial product considers the adverse impacts of investment decisions on sustainability.

The UK will also introduce new ESG disclosure requirements for Financial Conduct Authority (FCA)-authorized investment managers based on the recommendations of the Taskforce on Climate-Related Financial Disclosures (TCFD). The UK’s Joint Government-Regulator TCFD Taskforce has said the UK’s proposed rules will likely include disclosure of strategy, policies, and processes.

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The taskforce also said the proposed UK disclosure requirements will interact with related international initiatives, including the SFDR. While the UK will adopt a similar regime, the rules are unlikely to be identical, said Akin Gump.

“Investment managers will need to assess the direct and indirect application of the SFDR on their operations,” lawyers for Akin Gump wrote on the JD Supra legal information site. “A first step for many investment managers is to consider the ability and willingness of the business to comply with the requirements and the extent to which compliance is possible.”

The firm said investment managers should assess their existing ESG policies and practices against the SFDR requirements to identify any gaps. It added that investment managers will need to keep in mind the potential divergent approaches taken by the EU and the UK in developing their own ESG-disclosure standards.

“The compliance exercise may require the introduction or revision of ESG policies, and extend to other policies and procedures,” said Akin Gump. “This may require the development of additional benchmarks or investment criteria, the introduction of additional data providers, or new technology in order to provide the business with the means required to implement the new policies in practice.”