China A Shares - Suitable for Market Neutral Investing?
Gene Reilly, Greenwich Quantitative Research's Chief Investment Officer, speaks with Leyla Gulen about the suitability of China A shares for market neutral investing.
Leyla Gulen (00:00):
Hello, and welcome. I'm Leyla Gulen. I'm the co-host of Quantitative Investment Insights presented by Greenwich Quantitative Research. Greenwich Quantitative Research is a hedge fund based in Greenwich, Connecticut, focused on market neutral quantitative investing in the Asia Pacific region. I'm here with my co-host Gene Reilly. Gene is the founder and Chief Investment Officer of Greenwich Quantitative Research. Gene has 30 years of experience trading and investing including 19 years living and working in Asia. In terms of career highlights, Gene was a partner at Goldman Sachs and ran equity trading for them across the region. Gene also has substantial quantitative investing experience and more recently ran global quantitative trading for Merrill Lynch in New York. Our topic today is the Chinese onshore equity market’s suitability for quantitative market neutral investing. Well, Gene, it's great to have you. Why is this such an important topic?
Gene Reilly (01:00):
Leyla, thanks for that kind introduction. I'm really excited to be speaking with you today. The question is a great question. I've been speaking to pension funds, endowments and sovereign wealth funds over the last few years about our quantitative market neutral hedge fund product in Asia Pacific, which allocates over 30% to the Chinese A share market. We frequently get the question, “How do you do that in China?” People didn't think shorting stocks was possible in China. And it's a really understandable question. Shorting stock wasn't permitted for a very long time, and the rules have only evolved in the last few years to permit short selling. We realized there was a lot of appetite for content on how the China market has evolved.
Leyla Gulen (01:44):
Well, I agree. And I think it's a topic of great interest for many investors, perhaps before we dive into the discussion, we should talk about your time in Asia. When did you first move there?
Gene Reilly (01:54):
Leyla, I moved to Japan in 1994. Pre-internet, pre cell phone.
Leyla Gulen (02:00):
When did you first visit China?
Gene Reilly (02:02):
I went to China in 1995, in entirely a personal tourism capacity. Beijing was at that point, all bicycles and low-rise buildings. It didn't look anything like what it would come to look like in recent years.
Leyla Gulen (02:20):
Yeah, that's pretty incredible. When did you first go back to China in a more professional capacity?
Gene Reilly (02:25):
It was 2004 and Hank Paulson, the former treasury secretary, and then, the CEO of Goldman Sachs, where I was a partner, was very focused on the Chinese opportunity. He visited China over 60 times and ultimately won approval for Goldman Sachs to set up the first international investment bank in China. That led to me being very involved in the planning and execution of an equity trading business in China.
Leyla Gulen (02:48):
So if Goldman was the first investment bank in China, then you must have been one of the first American traders involved in trading Chinese equities.
Gene Reilly (02:57):
Yes, yes. I guess that's right.
Leyla Gulen (02:59):
Yes. So that gives you a lot of perspective. Putting politics aside, what's the importance of China to pension funds and endowment investors?
Gene Reilly (03:09):
Major global equity markets in terms of volume and market capitalization - China is, as of the fourth quarter of 2020 second to the US, both in stock market capitalization - 10 trillion versus 50 trillion - and turnover - 29 trillion versus 48 trillion in annual turnover. But historically, foreign investor participation has not matched the importance of the size of the market. The access to the market wasn't easy and there were political concerns.
Leyla Gulen (03:38):
So Gene, many investors and asset allocators are still underweight China and not aware of the different types of strategies that can currently be run successfully in China. And can equity market neutral strategies, including equity quantitative market neutral strategies be run successfully there?
Gene Reilly (03:57):
Yes. Absolutely. China has delivered many market opening changes to improve global investor access since launching the Shanghai and Shenzhen exchanges in 1990. Progress in the past five to seven years has been substantial, contributing to China being added to major global benchmarks, such as MSCI and FTSE's global and emerging market indices. There are still further measures that need to be introduced to bring China in line with global capital market standards, but investors can now implement most types of equity investment strategies, including equity quantitative market neutral strategies by accessing Chinese A-Shares through the programs that China has offered. Investors can potentially find profitable investment opportunities in China due to the unique market micro structured characteristics.
Leyla Gulen (04:44):
If you had to list the most meaningful reforms China's implemented over the past 20 years or so to get us to the current level of market openness that we see, which would you mention? And we can dive into them in more detail a little bit later.
Gene Reilly (04:59):
Yes. Initially there were many obstacles to investing in China, including the convertibility of the Renminbi. In 2002, the Chinese QFII program launch was a key milestone. It gave qualified investors access to the Chinese A-Shares. Previously only domestic investors could access A-Shares. In 2014, Shanghai, and in 2016 Shenzhen Connect program launches provided a channel to access Chinese A-Shares to a much wider range of investors and greatly simplified all aspects of setup and execution, including the ability to short using broker inventory. In 2020 QFII reforms solved many of the issues investors had with the original QFII and RQFII programs.
Leyla Gulen (05:43):
What are the different channels for China equity market access that are currently available to investors?
Gene Reilly (05:49):
Foreign investors have a number of options to access the Chinese A-Share market. There's the Qualified Foreign Investor scheme. This was formally known under two separate but similar programs, the Qualified Foreign Institutional Investor, program commonly known as QFII, and the Renminbi Qualified Foreign Institutional Investor program, commonly known as RQFII. The two independent programs were merged in November of 2020, along with some major reforms to program rules. Additionally, the Hong Kong-Shanghai and Hong Kong-Shenzhen Connect programs were launched. Additionally, there's been access granted to onshore futures, offshore derivatives exist as well.
Leyla Gulen (06:33):
Were foreign investors able to trade any China listed equities prior to the Qualified Foreign Institutional Investors launch?
Gene Reilly (06:41):
In 1992, foreign investors were granted access to the China B-Share market. Before 2001 only foreign investors were allowed to invest in B-Shares. As a result of the policy, not many strong companies chose to issue B-Shares. Since there were fewer investors and not many strong companies issued B-Shares, not many investors invested in B-Shares either so it was a marginally successful program.
Leyla Gulen (07:07):
Let's look at the QFII and RQFII and Connect access programs in more detail. What is the difference between QFII and RQFII?
Gene Reilly (07:15):
The QFII and RQFII programs were merged in 2020 as we mentioned. The channel is now known as just QFI. Prior to the merger, the two programs were separate, but similar in the rules. The major difference between the QFII and the RQFII programs were QFIIs needed to convert foreign currency into Renminbi in order to invest in China. Whereas the RQFIIs had the ability to utilize offshore Renminbi to invest in China.
Leyla Gulen (07:42):
Okay. If the programs were so similar, why do you think China even introduced RQFII? It seems to add confusion and complicate a process that really should be more simple.
Gene Reilly (07:52):
RQFII was launched in 2011, mainly to promote the internationalization of the Renminbi. Additionally, RQFII is based on jurisdiction. RQFII is restricted to investors in 19 specific countries, including Hong Kong, Singapore, the US and London among others. It's a way for Chinese policy makers to offer something of value in terms of market access to these countries.
Leyla Gulen (08:18):
Could all international investors use the QFII and RQFII channels?
Gene Reilly (08:22):
There was restricted access. It allowed direct access to Chinese capital markets for international investors who met specific qualifications. The assets under management restriction was set at a very high level, so medium and small asset managers didn't qualify. Additionally, there was a requirement for years of incorporation that was set at a high level so many new firms didn't qualify. China established the QFII program with the intention of attracting long term investment and required investors to be long term and strategic in their style of investment. Hedge funds did not meet the requirements for QFII or RQFII licenses. It was a quota based program, each individual QFII license entitled the holder to a specified quota amount that could be invested. There was a cap on the overall quota across all combined QFIIs. In 2002, the total available quota for quota for all investors was limited to only four billion US dollars, but expanded a number of times increasing to 300 billion in January of 2019.
Leyla Gulen (09:27):
Wow. So QFII and RQFII were very restrictive programs. What products could investors access through QFII and RQFII?
Gene Reilly (09:36):
The product scope was somewhat limited. Approved products included domestic RMB denominated stocks, including secondary market trading, IPOs and secondary offerings. Warrants, right issues, ETFs, open and closed end funds, index futures, some fixed income instruments and FX derivatives . Short-selling was not allowed, and for stocks QFII and RQFII accounts could trade essentially all the A-Shares listed in Shanghai and Shenzhen.
Leyla Gulen (10:04):
QFII and RQFII represented a partial opening of China's equity markets to foreign investors. I can see why major international benchmark providers such as MSCI and FTSE did not add China to their EM benchmarks even after QFII and RQFII were introduced. So how popular were the programs among investors who did qualify?
Gene Reilly (10:30):
Quotas were never fully utilized and only a limited number of financial institutions applied for and received their own QFII and RQFII quotas. Data from May of 2020 reveals that a total of 116 billion was granted to 295 QFIIs while 106 billion was granted to 230 RQFIIs. The QFII and RQFII merged in November of 2020 and is just known as QFI.
Leyla Gulen (10:57):
How does the Connect program differ from QFII and RQFII? Can you give us some details of the Connect program?
Gene Reilly (11:03):
Sure. In terms of the Connect program, the Shanghai-Hong Kong Stock Connect and Shenzhen-Hong Kong Stock Connect programs are collaborations between the Shenzhen Stock Exchange, the Hong Kong Stock Exchange, and the Shanghai Stock Exchange where overseas and mainland-Chinese investors can trade securities in each other's markets through the trading and clearing infrastructure of their home market. So there's the Northbound flow where overseas investors can transact via the Hong Kong stock exchange into the Chinese exchanges. And there is the Southbound order flow, in which mainland Chinese investors can buy and sell stocks on the Hong Kong Stock Exchange.
Leyla Gulen (11:41):
Mm-hmm (affirmative). Is the connect program as restrictive as the QFII and RQFII programs.
Gene Reilly (11:47):
Yes and no. The Stock Connect program is open to all clients of the Hong Kong Stock Exchange. Any investor can open an account and a Hong Kong broker can use the Connect channel to trade Chinese equities. However, there are restrictions and the entire universe of Chinese equities cannot be traded via the Connect program.
Leyla Gulen (12:08):
QFII and RQFII provided access to all A-Shares listed in Shanghai and Shenzhen. Is it the same with Connect and can you discuss the Connect product scope?
Gene Reilly (12:20):
Sure. As I was alluding to earlier from an eligible security perspective, as of November of last year, the Shanghai Stock Connect program covers approximately 590 stocks and represents about 86% of the stocks listed on the Shanghai Stock Exchange. The Shenzhen Stock Connect program covers 846 stocks, and that's about 81% of the stocks listed in Shenzhen. A-Shares listed on the Shenzhen Stock Exchange, main board and the Star Market, and the Shanghai Stock Exchange main board, Small and Medium, and Chi Next boards are the only securities eligible for transaction through Stock Connect currently. So it's a large subset, but there are still securities that can't be accessed via that channel. Trading is limited to the secondary market. You can't participate in IPOs via this channel. There is no trading of ETFs. There is no trading of domestic futures, and that's really how the restrictions break down.
Leyla Gulen (13:23):
QFII-RQFII is a quota based system. So are there any quotas on Connect trading at the individual investor or market level?
Gene Reilly (13:31):
There are no quotas at the individual investor level. Initially China imposed a maximum daily quota for Northbound and Southbound flow together with an overall maximum aggregate quota. This was to ensure currency stability and to prevent one-way flows from impacting the Renminbi. The aggregate quota was abolished in August of 2016, as a further market liberalization measure. Maximum daily quotas are still in place, but have increased to 52 billion Renminbi for Shanghai Connect and 52 billion Renminbi as well for the Shenzhen Connect program. If the daily quota is exceeded during a continuous trading session or at the close, no further orders will be accepted for the remainder of the day. Investors are always allowed to place long sell-orders, but buy orders may be blocked if the daily quarter limit is reached.
Historically the daily quota limit was only triggered once on the first day of trading for Shanghai Stock Connect in November of 2014. The QFII quota limits have been removed in November, 2020. So it's even more unlikely that Stock Connect limits will be breached in the future. Brokers should have sufficient QFII to execute client orders. Clients can more easily get their own QFII.
Leyla Gulen (14:50):
So for investors who didn't qualify for the QFII and RQFII programs, Connect offers trying to access in a meaningful way, though, there are some product gaps compared with QFII and RQFII. Did Connect offer any market-opening measures that weren't present in the QFII and RQFII programs?
Gene Reilly (15:08):
Yes. International investors were able to execute equity buy and sell trades along with the necessary FX in the same day. The FX management process is essentially the same as on other international markets. The Stock Connect program solved the FX management and currency repatriation issues associated with the original QFII program. Along with other advantages over QFII and RQFII. Stock Connect has become the most used channel for accessing Chinese A-Shares. Also from a short selling perspective, a short selling of eligible securities is allowed within the framework of Stock Connect rules, but the only viable short selling channel is through utilizing equity swaps. Stock Connect permits margin trading, but this is typically a retail broker offering. Northbound investors usually obtain leverage via trading on equity swap with their prime brokers.
Leyla Gulen (16:00):
So it seems like the introduction of Connect was a really important development for investors to be able to achieve market neutral portfolios.
Gene Reilly (16:08):
Yes. It was absolutely a breakthrough. Prior to connect we would not have been able to run the very well hedged two-sided granular portfolios that we're able to execute in China today. It's opened up the ability for people to utilize equity long / short inventory at their prime brokers to achieve truly granular long short portfolios in China.
Leyla Gulen (16:31):
Compared with the developed markets, there certainly are a number of different access channels. It is complex and somewhat confusing. Why did it come about this way?
Gene Reilly (16:42):
Policy makers were very focused on market stability. That's critical to understand when looking at how the Chinese market financial reforms have evolved. Currency stability was especially important to China. The Renminbi is a restricted currency. What happened to many Asian markets during the Asian crisis and policy makers are very focused on not losing control of financial markets, especially the currency. And that is really a primary policy objective for them. Their methodology so far has been to open slowly. They do not want negative surprises that impact financial markets, the economy, or the society more broadly that are too big for them to control. They will continue to open incrementally if new products and channels are working effectively. Programs and products can overlap in some areas. That is not a concern to China, as long as there is market stability. When there are issues, China will make changes. For example, China became concerned with the impact futures were having on market stability during the 2015 market sell off. China significantly increased futures margin requirements and implemented other tightening measures. The CSI 300 futures daily turnover dropped from 400 billion a day to only four billion a day in dollar terms and has still remained at the four billion dollar level even now.
Leyla Gulen (18:07):
China's markets definitely sound very different versus developed markets. Can you outline for us the key differences that equity investors and asset allocators need to be aware of and to better understand?
Gene Reilly (18:19):
Well, firstly, you need to talk about the currency. It's a restricted currency and is subject to foreign exchange controls and there are purchase and sale restrictions on the sale of RMB by residents. There's purchase and sale restrictions on Renminbi by non-residents. There are restrictions and approvals required to transfer Renminbi across the Chinese border. Prior to February, 2004, holding Renminbi in offshore accounts was not permitted. In 2004, banks started offering Renminbi accounts for many international investors. The complexity of managing Renminbi exposure and hedging has been a challenge. It's also an investor / broker model. China has a very unique model for investors to open an account and trade domestic securities. In China, the broker only interacts with commissions and not the settlement proceeds. The CSDCC acts as the central counterpart and guarantees cash and security settlements outside of the broker channel.
There are also investor IDs. What is the significance of investor IDs? Investor IDs are used by Chinese regulators to monitor investor activity. So it's not just international investors that need IDs to trade in China. Every order that's sent to the exchange is tagged with a unique client identification number or investor ID. That's true for retail investors, as well as international investors. The investor ID is fully transparent to the exchanges in real time, which is very different from how other markets function. The brokers have complete visibility over each investor's account and are required by regulation to monitor investor activity. Also the domestic retail investor in China is very different. According to the Shanghai Stock Exchange, the Chinese equity markets are dominated by individual investors. The most recent data that we have suggests that 75% of the turnover on Chinese exchanges is via retail investors.
Short term trading and speculation are common. The turnover’s pretty high. That large retail participation has been cited as one of the reasons why the markets are consistently more volatile. In fact, when the data was last published in 2018, the Shanghai Exchange denoted that 83% of the turnover was retail and the Shenzhen Stock Exchange denoted that 86% of the turnover was retail. So really very, very significant retail participation.
Also there have been in the past trading suspensions referred to as voluntary trading suspensions. But there previously have been very big problems. It was cited by MSCI as a point that needed reform before China could play a larger role in some of the global market indices that MSCI promotes. So voluntary market suspensions that are suspensions requested by the listed company, not regulatory driven have historically been higher in China compared with other equity markets globally because China had a relaxed suspension requirement regime. At its peak during the market sell off in the summer of 2015, 1,433 of the Shanghai and Shenzen stocks were suspended from trading out of approximately a total of 3,100 listings. Regulators and exchanges subsequently implemented policies to reduce the number of suspensions. They've narrowed the scenarios where suspensions could be applied for and reduce the number of days that suspensions could be valid. The policy has been effective with daily suspensions now having dropped to less than 20 in 2019. Suspensions continue to remain low averaging around 20 per day. This is really significant because there's always been concern that trading suspensions could prevent companies or investors from getting their capital out of China. And that was really something that the international investor community felt was extraordinarily important.
Additionally there are some high stamp taxes and other costs. In China, there's a stamp tax on sell orders of 10 basis points that applies to both QFI and Connect channels. And there is about a basis point in exchange fees. So it's a slightly more expensive channel than other markets.
Leyla Gulen (22:35):
My understanding is that historically foreign investor participation in China's equity markets has mainly been long only. Is this correct and can you explain why?
Gene Reilly (22:45):
That's correct. It’s Investor access. Prior to the Connect program, China's restricted QFII and RQFII access to only long term strategic investors. Hedge funds and other type of investors could not receive QFII allocations. There were gaps in the program that prevented other strategies from being viable. Going back to those days there was no ability to short stock via either QFII or RQFII channel. There's an ability to do that now via the Connect channel, but the QFII channel was never good for that. Onshore futures are now available to QFII and RQFII clients for very limited use. They didn't allow them for active hedging that would typically be required for quant and other hedge fund strategies, and there's no day trading. A stock that's purchased, can't be sold until the following day. So you can't buy and sell a stock on the same day under the current regulations. Until recently equity market strategies and quantitative equity market strategies have been employed in the Chinese market to only a very limited extent relative to how international investors would've embraced market neutral equity investing elsewhere in the world.
Leyla Gulen (23:53):
I know you've already touched upon the major reforms that are part of the evolution of the China stock market and have brought us to the point where for the past three to five years, investors are able you deploy market neutral strategies. Can you discuss what makes China an attractive market for equity quantitative market neutral strategies, and what are the key features that differentiate the China opportunity versus other developed markets where the playing field is extremely competitive?
Gene Reilly (24:24):
Sure. We can discuss China's unique market microstructure along with some other key points to explain why China is potentially very good for equity quant and market neutral strategies. The first point is that retail investors dominate the Chinese equity markets. There's also extraordinary market breadth from both a sector and industry's perspective and depth. There's significant turnover on-shore. There's an ability to short with an increasingly large universe of securities that can be shorted. There's also very high turnover versus other markets. The daily market cap turnover velocity is approximately 1.6% for the Shanghai Stock Exchange and 2.1% for the Shenzhen Stock Exchange. Compare that to Japan, which is about 72 basis points and Australia's 66 basis points. And Hong Kong is approximately a percent of market cap. So it's a high-volume high-velocity market.
Also, maybe because of the large participation from retail, bid-offer spreads are on the lower end. It's approximately eight basis points for Shanghai and six basis points for Shenzhen. And the interesting thing about the market - the bid offer spread in China - is that it remains stable even when volatility picks up. Bid-offer spreads, widen slightly, but liquidity tends to increase during these periods. In most other developed markets, including the United States, when volatility goes up bid-offer spreads tend to widen. Also, maybe because of the, the high retail participation in the market, the closing auctions only account for about 1% of daily volume, where that's significantly higher in international markets.
Leyla Gulen (26:10):
Well, has the dominance of retail flow changed at all since China has been added to the major global benchmark indices, such as MSCI and FTSE? We would expect to see the percentage of institutional flow increasing due to foreign flows increasing.
Gene Reilly (26:26):
China markets are gradually becoming more institutionalized from two main drivers. As these flows increase in importance, they will impact the market micro structure over time. In terms of foreign investor participation in 2017, Connect Northbound, investor ownership was just 1%. By late last year, foreign investors owned and estimated 290 billion of A-Shares representing 9% of the free float market capitalization. Foreign investor appetite has increased for Chinese A-Shares due in part to inclusions in the major benchmarks, by MSCI and FTSE. And that is also caused in part by how easy the Connect channel has made it to transact there. Also, domestic mutual fund participation is growing. It's increased from 10% to 30% of A-Share free float over the last five years. But for now retail flows still dominate China.
Leyla Gulen (27:20):
Well, that was very informative Gene. The markets in Asia are really complex and that only covered China. Well, that's all the time we have. I'd like to thank our listeners and we look forward to covering more topics in the future. Gene, thanks again.
Gene Reilly (27:36):
That's great. Thank you so much.
Leyla Gulen (27:37):
We'll see you next time.