By Garry Hawker, Business Leader Asia ex Japan for Mercer’s investment consulting business

Chinese institutional investors are increasingly able to diversify their portfolio exposures through the use of greater QDII quotas. However, such opportunities are occurring in an environment of very strong domestic equity market performance coupled with expectation of an appreciation in the Yuan. As such, a question that a Chinese investor might ask is “Why bother with investing offshore?”

Chinese equity performance

The recent growth of the “A” share markets in China has been spectacular. However, the following chart puts this into a longer-term perspective. Figure 1 shows the performance of the Chinese equity market¹ over the period from 1993 until June 2007 compared with the MSCI World Index (in local currency terms) over the same period – this index is a commonly used measure for the performance of global developed equity markets.

Figure 1: Growth of Chinese and global developed equity markets (in local currency terms) over the period from the start of 1993 until the end of June 2007

Over the full period, the Chinese equity market outperformed global developed markets, rising by 12.6% per annum, while the global equity index rose by 10.0% per annum in local currency terms. However, this outperformance was entirely due to the dramatic rise in the Chinese markets over the last 18 months. Indeed, as of the end of 2005, global equity markets had achieved 9.2% per annum in local currency terms over the previous 13 years, while the Chinese equity composite index had only achieved 3.8% per annum².

Baring any policy induced sharp correction, we believe that it is reasonable to expect the Chinese equity market to generate higher expected returns³  in local currency terms than global developed markets going forward as faster economic growth in China should translate into higher corporate earnings. The degree of outperformance though is expected to be more modest than has been experienced in recent months.

However, Chinese equity markets have been considerably more volatile than global developed markets. We expect the volatility of Chinese Equities will continue to be higher than global equities, and we view volatility as a reasonable (if imperfect) measure of the uncertainty or risk of future investment outcomes. Notwithstanding the higher expected return from local equities, Chinese institutional investors who are risk conscious may therefore wish to include global developed market equities in their portfolios. Hence, the argument for inclusion of global equities is less focused on returns and more of the potential benefits of reduced risk.

The comments and analysis presented above relate to returns determined in local currency terms – that is, the US portion of the MSCI World returns is measured in USD terms, while the Japanese portfolio is measured in Yen terms, etc. However, a Chinese institutional investor will be more interested in the returns that they can expect to receive in Yuan terms. This is considered below.

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Chinese currency appreciation

Economists and market participants expect the Yuan to appreciate over time relative to the USD, although there is considerable difference of opinions about the speed and extent of such appreciation. As an input into this paper, we have surveyed more than 30 investment management firms about their expectations as to the “fair” value for the Yuan relative to the USD. The results are summarised in the following table:

Table 1: Summary of “Fair Value” forecasts of investment management firms of the Yuan:USD exchange rate

The median forecast is that the Yuan will need to appreciate to a level of 6.87 in order to be regarded as “fair value”. This equates to approximately a 10% appreciation based on the actual rate on 30 June 2007.

The lower quartile estimate of 6.38 would equate to approximately a 16% appreciation. The most extreme “fair value” estimate provided was that the Yuan could appreciate by 100% over the next decade.

The USD is not the only currency that a Chinese investor would be exposed to if it invests offshore. Indeed, the USD represents less than 50% of the global developed equity market (as represented by the MSCI World Index) and less than 40% of the global bond market (as represented by the Lehman Brothers Global Aggregate Index). Therefore it is also necessary to consider the extent to which other major currencies might move. The views of the surveyed investment management firms are shown in Table 2.

Table 2: Summary of “Fair Value” forecasts of investment management firms of the USD exchange rate relative to other major currencies

The median expectations are that the Euro and the GBP are currently around 14% and 16% overvalued relative to the USD, while the Yen is around 15% undervalued. Ignoring minor currencies for the sake of simplicity, reversion by the major currencies to the median “fair value’ levels would result in a net increase of approximately 3% to 4% in global equity and global bond markets expressed in USD terms. Applying the expected 10% appreciation in the Yuan, this will generate an expected reduction in returns in Yuan terms of around 6% to 7% relative to local currency returns, in the event all the major currencies revert to what the managers consider “fair value”.

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Forward looking analysis

Below we examine asset allocations under two assumptions for Yuan appreciation going forward. The assumptions adopted (over a 10 year time horizon) for the purposes of this exercise are set out in Table 3 below:

Table 3: Expected Return and Volatility assumptions for Chinese and global asset classes

We have assumed under Scenario 1 that the expected 6% to 7% reduction in returns in Yuan terms mentioned above for global equity and global bond markets will result in a 1% per annum reduction in the expected returns in Yuan terms over the next 10 years. Scenario 1 represents a steady adjustment towards “fair value”, with modest overshooting.

In Scenario 2, we assume a 2% per annum reduction. This represents faster currency adjustment with more significant overshooting. We assume in both scenarios that the foreign currency exposures associated with the global equities and global bond allocations remain unhedged.

To make sense of the various possible asset allocations, we have used efficient frontier modelling. The purpose of such modelling is to determine for each level of risk, the asset mix that produces the highest expected return. In this context, the volatility of returns is assumed to be a proxy for all investment-related risks.

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The efficient frontiers presented below have been created using the assumptions outlined above. Nominal returns are portrayed on the vertical “Y” axis and risk, as defined by standard deviation of returns, is described by the horizontal “X” axis. The frontier lines represent the most efficient (highest returning) combinations of the possible asset classes for each level of risk. The left end of each line represents more conservative asset mixes (i.e. more bonds) with the right end representing more aggressive asset mixes (i .e. more equities). Our first example considers just the inclusion of Chinese asset classes:

Figure 2: Efficient frontier based on Chinese asset classes

The following chart adds the global asset classes, assuming expected returns in line with Scenario 1.

Figure 3: Efficient frontier based on Chinese and global asset classes with expected returns for the global asset classes in accordance with Scenario 1.

The efficient frontier shown in black is the Chinese only portfolio efficient frontier. The movement of the frontier upward and to the left illustrates the diversification benefit of an allocation to global asset classes. That is, the risk/return position is improved through adding allocations to the global asset classes.

Finally, we add the efficient frontier based on the global asset classes with lower expected returns assumed under Scenario 2. This is represented in Figure 4 by the red line.

Figure 4: Efficient frontier based on Chinese and global asset classes with expected returns for the global asset classes in accordance with Scenario 2

Figure 4 demonstrates that under Scenario 2, although the improvement in overall risk-adjusted returns is not as great as under Scenario 1, there is still some improvement.

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As a basis for comparison, we will assume that an investor (whose portfolio is marked-to-market each year) is prepared to accept a 25% chance of experiencing a negative return in any one year. In this case, the “efficient” portfolios from each of the three frontiers associated with this risk profile (and the expected returns) would be:

Table 4: Efficient portfolios associated with a risk profile associated with a 25% chance of achieving a negative return in any one year

Under either scenario, the diversification benefit of allowing an allocation to global asset classes reduces risk along the frontier which, in turn, allows a greater allocation to riskier assets – particularly equities – for the given level of risk.

For the level of risk considered above, the equity allocations effectively double to 45% under Scenario 1 and 40% under Scenario 2. The lower risk cash allocations of the Chinese-only portfolio are re-allocated to global asset classes under each scenario.

Under Scenario 1, global bonds are sufficiently attractive for a meaningful allocation (at least 5%) to be made, although the 2% per annum reduction in expected returns makes the asset class unattractive under Scenario 2.

The increased allocations to equities in turn lead to greater expected return. Under Scenario 1, the expected return improves by 1.0% per annum. Under Scenario 2, the improvement is 0.5% per annum.

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Conclusion

The survey conducted as background to this analysis revealed a median expectation amongst investment managers that the USD will depreciate against the Yuan by 10% over the medium term (although the range and pace of expected currency appreciation varies widely). The Euro and the Pound are expected to depreciate against the USD while the Yen appreciates.

This, compounded with greater equity return expectations from the Chinese market than the global market as a whole (over the long term), renders global asset classes less attractive to Chinese domestic investors.

However, the lower expected return volatility of global equity markets (relative to Chinese equities) means that global equities still have a place in Chinese domestic portfolios. Moreover, the relatively low correlation of global and Chinese asset classes implies a diversification benefit from investing in these asset classes to domestic investors.

Our analysis supports the view that Chinese domestic investors will benefit from the greater freedom to invest overseas. The risk reduction afforded by such diversification allows for a greater allocation to riskier asset classes (particularly equities) for a given risk tolerance. Increased allocations to equities lead to greater expected returns. Of course, there is a risk that the speed of Yuan appreciation in the short term might be higher than that implied. However, this risk is to an extent mitigated by the likelihood that it would take some time to build up an exposure to global equities of the size outlined in Table 4. It will also be important to stress test the asset allocations to more extreme levels of appreciation.

The answer to the question posed in the abstract for this document is therefore clear: “You should bother with investing offshore – it will improve your expected risk-adjusted return.”

1. The Chinese equity market performance is constructed from a market capitalisation-weighted combination of the ‘A’ and ‘B’ shares indices for both the Shanghai and Shenzhen exchanges.
    
2. Note that the MSCI series used includes the reinvestment of dividends while the Chinese composite does not. The dividend yield of the Shanghai A Share Index as reported by Bloomberg has averaged less than 2%, which would not have been sufficient to cover the performance differential of the two asset classes over the period ending 31 December 2005.
    
3. It is important to note that the term “expected return” has a specific meaning in the context of this paper and this type of analysis that differs from its intuitive meaning to a layperson. The expected return represents the estimated midpoint of an uncertain range of potential future outcomes, not the return that we “expect” (taking the normal meaning of the word expect) to achieve. We can state that we will almost certainly not achieve exactly the expected return that is specified. If the reader substitutes “midpoint of uncertain range” for “expected” in reading this report, this will provide a useful reminder.

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© 2007, Mercer Human Resource Consulting Pty Ltd

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