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Research

Assessing alpha potential for China-focused hedge funds

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There are structural reasons why Chinese equities provide a fertile ground for alpha. First, continued flows into China could have potential to support both beta and alpha. China accounts for only 8.5% of the world market cap, in contrast with its 16% share of the world GDP or 10% of world capex. Widening market access and a heavier share of China in EM and global indices would attract flows. 

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Assessing alpha potential for China-focused hedge funds
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Second, market depth, essential for alpha, would improve thanks to a richer set of businesses, types of investors and corporate operations. In particular, capitalization by state-owned enterprises (SOEs) now accounts for less than 40% of the total (~100% a decade ago). This makes room for more private companies now accessible via the Stock Connect, with a healthy pipeline of IPOs. While far from DM’s, the free float percentage is growing (~40% today), improving minority shareholders’ safety and liquidity. The A-shares market, still dominated by retail flows and driven by momentum, does provide arbitrage potential but remains vulnerable to correlation risk. Rising institutional ownership, including foreign investors and pension funds, would offer more stable alpha. Stock shorts—still heavily regulated—remain encouraged, which also increases market depth while tempering investors’ exuberance. 

Third, multiple themes provide numerous catalysts, including the transition from an export to a consumption-driven model with a stronger middle class, a rapid urbanization, the rise of innovation leaders in tech and beyond, an ageing population, industrial consolidation in sectors facing excess capacity, and improvements in corporate governance. Foreign stocks sensitive to China also can offer safer proxies to get Chinese exposure, though these stocks diverged from inland indices in recent months, resulting from uneven trade war impacts.

Structural challenges call for specialists. Uncertainty regarding trade policies, supply chains, foreign market access, and CNY volatility might persist for longer. Moreover, Chinese markets remain policy-driven with vulnerability to changes in economic stimulus, credit access, regulations, state control over SOEs, and stock suspensions. Elevated corporate debt also calls for serious risk management, as well as rising instability in Hong Kong.

The current alpha backdrop could improve in a trade truce scenario. Alpha generation has been volatile over the past two years, impaired by the dominance of trade and tech wars. Poor fundamental pricing is apparent in the high share of stock moves attributable to broad markets. Yet, multiple themes and uneven impacts from trade policies result in low stock correlation, limited sector leadership and greater price discrimination. Stocks are also cheaper, thus providing stock-picking potential. Moreover, prospects of a trade truce are opening fresh opportunities, while our tactical indicators don’t point to a major risk of reversal.

In a trickier backdrop, managers favor cautious exposures (<0.5 of beta). Over time, we estimate that alpha has contributed to 40% of their returns from market-timing and bottom-up selection rather than from factor investing (not a decisive driver in China). The average funds return correlation across our basket of China L/S Equity funds reflects a healthy pool of opportunities.

A trade truce would improve mixed current alpha conditions. In the long-run, passive and active styles both seem fit for Chinese exposure. Yet, as markets become moderate once more, a rebalancing toward active strategies would gain traction.

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