How Chinese Equity can Enhance Global Equity Portfolios
November 1, 2017
Investment Director – Equities
In October of 2017 Mackenzie Investments launched the Mackenzie All China Equity Fund – an actively managed fund focused on investing in companies located in China. This article outlines some of the historical risk and return characteristics of the Chinese equity market. It also helps answer questions about the potential impact of Chinese equities on globally diversified portfolios.
When selecting a new fund for a portfolio, investors often ask: What benefit does the fund give me? That is, what does adding this fund in combination with the other investments do for my portfolio? This question is usually answered in one of two areas:
- What happens to the returns in my overall portfolio
- What happens to the risk in my overall portfolio
Once we have that information in hand, a natural follow-up question is, ‘How much is the right amount to put in my portfolio?’ With a little guidance and evidence, most investors can make up their minds in a sound way about what is right for them, given their preferences. What matters to investors are returns, risks and correlations of the markets. Investors naturally want higher returning assets for lower risk. When any two assets are put together that have low correlation, the effect is to lower the overall risk of the portfolio, when compared to assets that have high correlation. This is commonly referred to as the diversification effect.
If an investor is considering a Chinese equity fund, we can look at historical behaviour as a guide to the risk and return differences in the Chinese market compared to other markets. While returns have been very good for investors in the Chinese market, investing in China has been, historically, more risky than investing in other parts of the world (see chart above). Being invested in a market with higher returns can enhance the returns of the whole portfolio. However, when the investments are more volatile, the higher risk of those investments means the risk in the overall portfolio might also increase. In reality, risk does not rise proportionally, due to the diversification effects from the Chinese stock market versus other global markets.
Over the past 15 years, Chinese markets have significantly outperformed global markets in Canadian-dollar terms, with about twice the volatility (risk). Seen in the correlation table below, Chinese markets have also offered Canadian investors better diversification compared to Global Equity Efficient Frontier on average.
|S&P/TSX Composite||S&P 500||MSCI EAFE||China Equity|
|S&P 500 TR||0.5||1.0|
|MSCI EAFE NR||0.6||0.8||1.0|
Source: Mackenzie, Morningstar at 08/31/2017
* China Equity is represented by a Blended Benchmark from December 1, 2001 to May 30, 2008 which is composed of 50% MSCI China A Index & 50% MSCI China Index; from June 1, 2008 to present which is composed of 100% MSCI All China Index.
When making a decision on a Chinese equity allocation, we can offer some examples to help guide investors.
On its own, Global Equity has returned 10% since investors began measuring global equity returns in 1970 (i.e., without Chinese equity). By comparison, Chinese equity markets returned about 13% since 2001, the earliest point at which we were able to construct the data. But those returns came with significantly more risk than developed markets. In this piece, we put those two markets together to construct all possible portfolios for investors who are allocating between global developed equity markets and Chinese equity markets.
An 'efficient frontier' is a curve that plots all portfolios that maximize return for a given level of risk with the assets being used. In effect it is the best one could have done, from a risk-return perspective, investing in these assets. Each point on the line represents a different portfolio, and each portfolio has different return and risk outcomes. With any set of investments, an 'efficient frontier' is the line that plots all portfolios which maximize return for a given level of risk. In effect it is the best one could have done, from a risk-return perspective, investing in these investments. Each point on the line represents a different portfolio, and each portfolio has different return and risk outcomes.
In the chart Global Equity Efficient Frontier, we constructed the efficient frontier by plotting all possible portfolios of Chinese and Global Developed Market equity only. We plotted three example portfolios that were selected as appropriate for conservative, moderate and growth investors, respectively. The allocations represent the equity portions of each investor portfolio:
Conservative: Adding 5% Chinese equity to a globally diversified portfolio increased the return potential from 10% to about 10.1%, with a marginal increase in risk from 16% to 16.1%.
Moderate: Adding 15% Chinese equity to a globally diversified portfolio increased the return potential from 10% to about 10.4%, with a commensurate increase in risk from 16% to 16.4%.
Growth: Adding 25% Chinese equity to a globally diversified portfolio increased the return potential from 9% to about 10.7%, with a meaningful increase in risk from 16% to 17%.
We evaluate these allocations against one another, and measure their success in terms of the risk-adjusted returns they generate. Using this criteria, and despite not achieving the highest absolute return, an investor would have been better off selecting the moderate portfolio because it’s the option that maximizes the risk-adjusted return (Sharpe ratio) across all options.
To give investors diverse access to China’s equity market, Mackenzie Investments partnered with asset manager China AMC to launch the Mackenzie All China Equity Fund. This investment solution offers global diversification, a low correlation to Canada’s market and high growth potential.
Generally, adding Chinese equity to a global equity portfolio has increased the returns and risks of the overall portfolio over time. While investors need to assess how much exposure to China equities is appropriate for them, a small amount can make an impact on the returns without having an outsized impact on risk in the portfolio, and improve risk-adjusted return.