A Sector-Balanced Approach to China A Mega-Cap Exposure

• A simple top-50 China A portfolio may lead to an uneven sector-weight allocation relative to the broader market. This poses a challenge for investors who target balanced market exposure through mega-cap holdings.
• We analyze a novel sector-balanced approach to achieve market-like exposures that may help investors implement a strategic and tactical asset allocation in the China A market.
• Such an approach could have been utilized in managing market risk and size-factor exposure of the China A market over different time horizons in various investment strategies.

There are different reasons investors may want to be exposed to the mega-cap segment of the China A market.¹ While some look for better accessibility, investment capacity and liquidity, others may find more comfort in the greater familiarity, information disclosure and potentially stronger governance practices from these “titan” companies.

Due to significant sectoral biases, a simple top-50 approach can pose a challenge to investors who desire market-like exposures. We explore how a balanced mega-cap approach could have been used to refine the size exposure in an existing portfolio, manage the systematic risk of the China A market and implement a core dedicated China A allocation.

What Could a Balanced Mega-Cap Approach Look Like?

While there are different ways to address these challenges, MSCI’s methodology used to construct the MSCI China A 50 Connect Index, for example, was designed to achieve balanced exposure to China A mega caps. We use this index as a proxy for a balanced, mega-cap approach.

Starting from the parent MSCI China A Index constituents, we first select at least two large-cap securities from each Global Industry Classification Standard (GICS^®)² sector before filling the rest of the 50-stock universe based on their weight in the parent index.³

The weight of each sector in the final MSCI China A 50 Connect Index is designed to mirror the corresponding weight in the broader MSCI China A Index to ensure no sectoral biases, and securities are weighted according to their market-capitalization weight, within each sector.

MSCI China A 50 Connect Index Construction

The decoupling of security selection and the weighting process helps ensure the resulting index has security representation in each GICS sector and balanced sector-weight allocation. As seen in the exhibit below, compared with a simple, hypothetical top-50 index, the MSCI China A 50 Connect Index was less concentrated in the financials and consumer-staples sectors and allocated more to information technology and materials.

Sector Concentration of the MSCI China A 50 Connect Index vs. a Top-50 Approach

Data as of June 30, 2021. Top 50 is a simulated index selecting the largest 50 stocks by weight, based on the MSCI China A Index. Sector allocation of the MSCI China A 50 Connect Index does not exactly match that of the MSCI China A Index mainly due to intra-rebalance security price fluctuations.

With this approach defined, we examine how it could have applied to the three investor objectives outlined above.

Refine Size Exposure in China A Portfolios

Investors may want to periodically neutralize their bet on the size factor, especially some factor-based and active strategies that may have significant exposure to the factor. In addition, megatrend strategies such as those focusing on disruptive technology could be more commonly identified in the small- and mid-cap space. The exhibit below shows that the size factor of the China A market experienced heavy volatility in recent years and managing the size exposure may have become crucial.

Size-Factor Exposure of Selected Indexes and CNLT Size-Factor Returns

Size exposure and factor return are based on the MSCI Barra China A Total Market Equity Model (CNLT). Active Size Exposure is calculated relative to MSCI China A Index. “Diversified Multi-factor” refers to MSCI China A Diversified Multi-Factor Index. “Risk Weighted” refers to the MSCI China A Risk-Weighted Index. “Tech 100” refers to the MSCI China A Onshore Tech 100 Index. “Future Mobility” refers to the MSCI China A Onshore IMI Future Mobility Index. “Robotics” refers to the MSCI China A Onshore IMI Robotics Index. Active manager portfolios are based on the annual/semi-annual disclosures of all active equity mutual funds in the China A share market. The CNLT Model is designed to capture the growing dynamics of the China A Share market. Data from Dec. 31, 2013, to June 30, 2021. Source: MSCI, Wind.

Manage China A Market Risk

Using the MSCI China A 50 Connect Index as proxy for a balanced, mega-cap approach, we found that on a three-month rolling basis from November 2012 to June 2021, the index had consistently higher correlation with and lower tracking error to the MSCI China A Index, compared with a simple top-50 index.⁴ These market-tracking characteristics may have been useful in managing risk for a wide array of investment strategies.⁵

Three-Month Rolling Correlation with, and Tracking Error vs., the MSCI China A Index

Data from November 2012 to June 2021.

Implement a Core Dedicated China A Allocation

To simplify the implementation of a dedicated allocation to the China A market, some investors may prefer a more concentrated portfolio of large, well-known names to a full-blown broad market approach, but may have concerns around investability, profitability and governance metrics. In the exhibit below, we compare these characteristics, again using the MSCI China A 50 Connect Index as proxy for the mega-cap approach and the MSCI China A Index for the broader market.

MSCI China A 50 Connect Index vs. MSCI China A Index

*As of June 30, 2021. **Average from November 2012 to June 2021.

In short, we found that a balanced mega-cap approach overcame the sectoral biases of a simple top-50 approach. This tool can be used to help refine the size exposure in an existing portfolio, manage the systematic risk of the China A market and implement a core dedicated China A allocation.

¹The mega-cap segment typically refers to the top 10-50 stocks by size (measured by asset, revenue, market capitalization or other metrics) in a given market, depending on the breadth of reference market.

²GICS is the global industry classification standard jointly developed by MSCI and S&P Global Market Intelligence.

³The MSCI China A Index captures large- and mid-cap representation across China securities listed on the Shanghai and Shenzhen exchanges.

⁴This closer tracking of the broad market was even more pronounced during the 2015 China A market crash when a significant performance divergence was observed between large- and small-cap stocks.

⁵High-conviction investors may seek to hedge market risk to play the pure “alpha,” and quantitative/systematic strategies sometimes hedge market risk to capture the pure “factor risk premium.” In addition, market timers and asset allocators may make use of liquid and “shortable” instruments to express market views or capture time-series factor-risk premia.

Further Reading

Considerations for Dedicated China Equity Allocations

Foundations of Dedicated China Allocations - Part 1: Investment Policy and Asset Allocation

Foundations of Dedicated China Allocations - Part 2: Configuring and Implementing Asset Allocation

China and the future of equity allocations

Emerging markets since China A shares’ inclusion