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Blog Posts — February 14, 2019

Building “Smart Beta” Strategies for China A Shares Using the New AXCN4 China Equity Risk Model

This post was written by Yurong Gu, Analyst, and Frank Siu, Executive Director, on Axioma’s Index team.

Global index vendors have spent much attention in recent years on the possible inclusion of Chinese A Shares in their investible benchmarks.  The domestic Chinese equity market – hitherto accessible to only a small handful of foreign investors – had begun opening up, thanks to rapid expansion of the RQFII scheme and the introduction of platforms like the Shanghai-Hong Kong Stock Connect programme. 

Analyses have almost exclusively focused on the addition of China A Shares into traditional capitalization-weighted indexes and the resulting changes in portfolio exposures and characteristics. Interestingly, there has been little discussion on the how this new investment opportunity set impacts so-called “Smart Beta” indexes and factor investing strategies more broadly.

Using analytics from the Axioma AXCN4 China Equity Risk Model, we find that the China A Share market is in fact ripe for the development of such products.  Factors with a strong academic and empirical track record of positive premia in other global equity markets also exhibit attractive performance in China, despite a relatively insular market and idiosyncrasies unique to A Shares.  Factor-Mimicking Portfolios (FMPs) constructed using select factors from the AXCN4 model show steady gains through time, albeit interlaced with some factor cycles.

Admittedly, FMPs are by-products of regression arithmetic and do not necessarily correspond to real-world tradable portfolios.  We proceed to construct a long-only equity portfolio strategy tilting on a selection of factors – Value, Momentum, Quality (Profitability, Low Leverage), Small Size, and Low Volatility (Low Idiosyncratic Volatility, Low Beta) – while employing realistic portfolio construction rules, with limits on risk/exposure, trading/liquidity, and diversification.  The strategy rebalances monthly, sampling from the CSI 300, and manages to achieve annualized outperformance of 8.75% with an Information Ratio of 1.22 during its 14-year backtest period.

Skeptics often cite the phenomenon of sporadic and prolonged trading suspensions (even for prominent large cap names) unique to the Chinese stock market, as a major hurdle to global benchmark inclusion and why factor strategies may not be viable or profitable for China A Shares.  We thus modify our simple portfolio strategy above to account for trading suspensions, by disallowing any trading of suspended names.

Finally, to simulate the feasibility of these strategies for foreign investors, we incorporate data reflecting at each point in time which stocks were tradable via the Shanghai/Shenzhen Hong Kong Stock Connect.  Additionally, Stock Connect listings designated as “Sell-Only” are taken into account during the relevant periods; during each rebalance, the optimizer can only unwind, not further upweight, such names. Below are the cumulative and yearly performance of three strategies: the original multi-factor formulation; a “suspension-aware” version; and one that takes into account both suspensions and Stock Connect limitations.  Even after taking both trading suspensions and Stock Connect access into account, the multi-factor portfolios still outperform the broad CSI 300 by 7.83% per annum with an Information Ratio of 1.08.

Finally, we present a factor-based performance attribution of these strategies using the Axioma AXCN4 China Equity Risk Model.  Both before and after accounting for suspensions and Stock Connect access, the strategies tilt toward the “target” factors; and these exposures generally contribute positively to return as intended, while keeping return and risk contributions from sectors and stock-specific sources fairly muted.  In other words, the strategies derive almost all their return from factor risk premia and not specific stocks or incidental bets on sectors, evidenced by the fact that their performance profile remains largely unchanged despite material differences in the stocks present in their selection universe.

This specific portfolio strategy is by no means an exhaustive analysis of risk premia or the endless variations with which one could implement factor strategies in the China A Share market, but the results are extremely promising and come from a sufficiently realistic simulation that addresses some of the alleged obstacles against implementing successful systematic strategies in China.  Transparent and robust factors, effective risk and exposure management, and quantitative portfolio construction are some of the key ingredients in an “Smart Beta” product, and the new AXCN4 China model, coupled with the broader Axioma ecosystem of portfolio optimization and analytics, provides an ideal toolset for researching and developing factor investing for China A Shares.