A Different Approach to China’s Equity Markets

Few countries have the ability to influence global markets to the degree that China does. Investor sentiment here can have significant implications for both developed and emerging markets. The second half of 2015 has been difficult for China’s equity markets, to say the least.   • Lower Economic Growth: China is undergoing an important transition from investment-led economic growth to having consumption play a more significant role. A critical result of this shift could be that the former double-digit levels of year-over-year economic growth truly become a thing of the past.¹ This has also had implications in the commodity markets, as one key factor influencing commodity price behavior is potential demand from China. As we look at the S&P GSCI Index, down 33.40% year-to-date, this is definitely an important contributing reason.²   • Signals within Currency Markets: In early August 2015, a few adjustments to the value of the yuan compared to the U.S. dollar impacted market perceptions of China, making some wonder if there would be a "currency war" in Asia.³ We did not think that to be a high-probability event, largely due to China’s perceived desire for inclusion in the International Monetary Fund’s Special Drawing Rights (SDR) basket. Recently, the yuan did achieve this status, and we believe that the generally stable policy that China has taken—as opposed to making big changes with increasing frequency—was a large factor.⁴   What to Do in a Tough Chinese Equity Market   Seeing the difficulties experienced in China and broader emerging markets in 2015, one response might have been to avoid China entirely—certainly a valid point of view. However, China represents approximately 2.2% of the MSCI ACWI Index, currently the largest emerging market exposure in this Index,⁵ and it is also the world’s second largest economy,⁶ so dropping the exposure could introduce a substantial risk relative to global equity performance benchmarks. Additionally, the markets that China impacts stretch far beyond its borders. So if investors do not want to completely avoid China, what approach could make more sense than simply owning the broad Chinese equity market?   China’s Equities without Government Ownership On April 1, 2015, WisdomTree launched a China ex-State-Owned Enterprises Index. The WisdomTree China ex-State-Owned Enterprises Fund (CXSE), which tracks this Index before fees and expenses, was launched on July 1, 2015. Looking at the total returns at net asset value from this point through December 30, 2015, we’ve seen:⁷   • CXSE: -7.81% • Shanghai Composite Index: -14.96% • MSCI China Index: -19.81%   China’s equities tilting away from state-owned firms have delivered distinctly different performance from broader measures of China’s equity performance.   Drivers of China’s ex-State-Owned Equity Advantage in 2015 (Average Annual Returns as of September 30, 2015) • Differentiated Sector Exposures: CXSE has exhibited very different sector exposures than the MSCI China Index. Two approx.. 20% over-weights are in Consumer Discretionary and Information Technology. Financials, on the other hand, was a more than 21% under-weight. It’s also notable that Telecommunication Services, Energy, Utilities and Materials are sectors with under-weights within CXSE compared to the MSCI China Index.   • Significantly Different Sector Performance: To be fair, any sector performance advantage over this particular period is about being “less negative,” as opposed to finding stocks that are performing extremely well. The outperformance seen within CXSE’s Energy, Utilities, Materials and Telecommunication Services sectors over the same respective sectors within the MSCI China Index is basically about avoiding the big drawdowns that those sectors have seen recently.   Building Awareness of a New Way to Think About China’s Equity Markets Every ETF—including CXSE—represents a tool that provides access to a particular market. We believe that looking at China through the lens of firms that are not state-owned is something new that no other ETFs are doing. If the differentiated performance persists, it could be a very interesting new "smart beta" factor exposure that could apply beyond China to other major emerging markets.         ¹Source: Mark Magnier, “China Economic Growth Falls Below 7% for First Time Since 2009,” The Wall Street Journal, 10/18/15. ²Source: Bloomberg, for period 12/31/14 to 12/30/15. ³Source: Neil Irwin, “Why Did China Devalue its Currency? Two Big Reasons,” The New York Times, 8/11/15. ⁴Source: “IMF’s Executive Board Completes Review of SDR Basket, Includes Chinese Renminbi,” International Monetary Fund Press Release, 11/30/15. ⁵Source: Bloomberg, with data as of 12/30/15. ⁶Source: International Monetary Fund World Economic Outlook Database, October 2015 data update. ⁷Source for bullet points: Bloomberg.