As of May 29, 2015, the annual return of Shanghai A-shares was a phenomenal 125%.¹ On the other hand, real GDP growth in China continues to march toward lower levels, with policymakers setting a 7% target for this year, after it missed the 7.5% target for 2014. So how should investors weigh these seemingly conflicting data points in their global equity allocations? Which of the two data points matters the most for portfolios?

The answer is … neither of them!

We all know very well the hazards of chasing past performance, so I don’t need to elaborate. (For more information, see Quantifying the impact of chasing fund performance.) China has been dealing with slowing GDP growth for some time, and Vanguard research has shown that it can be misleading to form equity-return expectations based on the prospects for economic growth. (See The outlook for emerging market stocks in a lower-growth world.)

While (unexpected) economic news can certainly move markets sharply on a daily basis, the mistake is to extrapolate this short-term relationship to a long-term view, based on the expected economic outlook.

For instance, a subdued growth expectation for China may already be priced into the markets, so equity investors who buy a stream of slower-growing earnings at the right price may still earn normal returns. Keep in mind that lower growth should also translate into lower issuance of shares in that market; therefore, the supply-demand balance is preserved. For this main reason, focusing on the growth numbers of an individual country is the wrong way to approach long-term asset allocation decisions.

So how then should long-term investors manage their global equity portfolio construction? When investing in emerging markets in general, and in China particularly, the focus should be on diversification, not growth-related outperformance.

Investing in emerging markets and in China is about gaining exposure to a growing share of the world GDP. By growing at 7%, or even 6%, per year, China’s share of world GDP would continue to expand (catching up to its share of world population, as labor productivity converges to developed-world levels). It’s the share of world GDP, not the GDP growth rate, that long-term investors should take into account.

Moreover, as China continues with market-oriented reforms, including a gradual yet decisive push toward capital-account liberalization, we expect to see more deepening and development in Chinese onshore equity markets.

This means that China’s share in world investable equity markets may grow proportionally more than its share in global GDP. For instance, the recently announced China–Hong Kong mutual-recognition scheme (the Shanghai–Hong Kong Stock Connect), the upcoming Shenzen–Hong Kong connect scheme, and the Renminbi Qualified Foreign Institutional Investor (RQFII) quotas are all programs through which policymakers in China are gradually opening the economy to the flow of international capital.

The bottom line for global investors is that this is great news. Gaining access to the A-shares market in China will mean having more exposure to a much larger pool of Chinese companies, including smaller companies and certain market sectors that currently tend to be underrepresented in the H-shares (Hong Kong) market.² Thus, global market-cap equity benchmarks will be able to reflect appropriately the weight and composition of this large economy in the world investable markets, and investors will be able to capture the associated diversification benefits in their portfolios.

When it comes to long-term global equity portfolios, investors should pay more attention to China’s progress in terms of financial liberalization than to its well-known transition toward lower growth rates.

 

 

 

1 Source: Bloomberg. China A-shares are equity shares in mainland China companies that are traded on the Shanghai and Shenzhen stock exchanges and are only available to foreign investors through regulated systems, including the Qualified Foreign Institutional Investor (QFII) and Renminbi Qualified Foreign Institutional Investor (RQFII) systems, or the Shanghai–Hong Kong Stock Connect program.

2 H-shares are securities of companies incorporated in the People’s Republic of China and nominated by the Central Government for listing and trading on the Hong Kong Stock Exchange.

Notes:

Past performance is no guarantee of future returns.

All investing is subject to risk, including the possible loss of the money you invest.

Diversification does not ensure a profit or protect against a loss.

Investments in stocks issued by non-U.S. companies are subject to risks including country/regional risk and currency risk. Stocks of companies based in emerging markets are subject to national and regional political and economic risks and to the risk of currency fluctuations. These risks are especially high in emerging markets.