A Guide to Investing in Chinese Equities

Investing in emerging markets like China can provide attractive risk and return dynamics for growth-oriented investors. While political risk is a factor to consider in the Chinese market, the appetite for Chinese equity investments remains high as the country's economy continues to grow.

Periodically, the Chinese market faces challenges due to various local and global situations. These may stem from health policies, economic factors, or risks associated with specific sectors like real estate. However, over time, such situations often evolve, regulations adapt, and markets rebound.

Investing in Chinese equities may be a strategic move for investors looking for returns less correlated with U.S. and international developed markets. Other reasons to consider investing in the Chinese market include:

• Seizing the opportunity provided by the relative under-representation of Chinese equities in global stock market indices.
• Capitalizing on the potential for higher returns through investment in comparatively undervalued securities, as opposed to U.S. and international developed equities which often trade at higher valuations.

In today's guide, we'll explore both of these dynamics and outline the case for why investing in Chinese equities may provide long-term secular growth and highlight some exchange-traded fund (ETF) options for doing so.

Chinese equities are under-represented in the global equity market

When investors structure a portfolio, they commonly favor stocks from North America or developed countries like those in Europe or Japan. These preferences are typically guided by each region's representation in the global stock market. For example, an investor might allocate a significant 60% of their portfolio to U.S. stocks, mirroring its approximate 60% share of the world's market.

However, emerging markets like China present a different narrative. Despite China's substantial contribution to the global economy, its representation in global market indices is less prominent than its economic power would suggest. This is clearer when we compare the global economic shares of U.S., Japan, and China with their corresponding weights in global market indices:

1. The U.S. makes up about 24% of the world's economy, but its stocks hold a around a 60% share in global market indices.
2. Japan, which accounts for 5% of the world's economy, is roughly represented at the same rate in most world market indices at 5.5%.
3. But China, contributing to a significant 18.5% of the global economy, is often represented at less than 4% in world market indices.

Source: World Bank and MSCI, as of December 31, 2021.

It becomes evident that there is a discrepancy between China's GDP share and its representation in world market indices. This gap suggests a potential opportunity for investors to leverage the long-term growth prospects of China's economy, particularly when we consider its projected growth trajectory.

Based on the growth forecasts below, it's predicted that by 2030, China could outpace the U.S. to become the world's largest economy. This foresight emphasizes the importance of adequate representation of Chinese equities in investment portfolios for global exposure and growth potential.

Source: World Bank and MSCI, as of December 31, 2021.

Chinese equities appear undervalued

When it comes to assessing the value of stocks, investors often look at certain ratios such as price-to-earnings (P/E), price-to-book (P/B), and price-to-sales (P/S).

When it comes to investing in equities, understanding a company's valuation is essential. The valuation of a company gives you an idea of its current market value relative to its earnings, sales, or book value. This is crucial as it helps investors determine whether a stock is overpriced, underpriced, or fairly valued.

In the case of Chinese equities, their valuation ratios are much more attractive. Here's a simple comparison of the MSCI China index to the MSCI ACWI index on multiple metrics:

Bloomberg Finance L.P., as of July 21, 2022.

Investors tend to seek out stocks with low valuations because they are often seen as bargains - these stocks may be undervalued and therefore offer the potential for significant returns when their true value is realized by the market. Additionally, low-valuation stocks can provide a margin of safety, as they may be less likely to experience significant price drops compared to high-valuation stocks.

How you gain exposure to Chinese equities matters

Not all approaches to investing in Chinese equities will provide the full range of diversified exposure investors need. For example, consider the large discrepancies in sector weightings shown below due to the difference between investing in China H-Shares, which are traded on Hong Kong exchanges versus investing in the S&P China 500 index.

Source: S&P and MSCI, as of June 30, 2022. China H-Shares based on the MSCI China H Index

An investor relying solely on H-Shares would end up grossly over-exposed to financial sector stocks, while under-weighting most other sectors. This would result in their Chinese equity exposure being skewed, which could result in greater tracking error.

On the other hand, the CI ICBCCS S&P China 500 Index ETF (TSX: CHNA.B) tracks the S&P China 500 Index, which provides exposure to the largest, most liquid Chinese equities across all Chinese share classes. This includes A-Shares, which are listed and traded only on mainland Chinese exchanges and offshore listings. The result? A much more diversified and even sector weighting, as seen below:

Source: S&P, MSCI, FTSE and CSI, as of June 30, 2022.

ETFs like CHNA.B can provide more affordable, liquid, and diversified exposure to a broad range of Chinese equities. For more information on CHNA.B, check out the fund's page on our website.