The Great Fall of China – what really happened?

The media has had a ball with this one…

Firstly, let’s separate the “share market” from the “economy”. The value of a share market is simply the price of the companies listed there as determined by their investors – the buyers and sellers of those shares. Share market performance is not linked to the GDP or economic growth of a country, it does not impact unemployment rates or any other measure of the economy. A 10% drop in a share market does not mean a 10% deterioration of an economy. The economy in China continues to grow at a rate of around 7% per annum – a growth rate that developed economies are envious of.

Secondly, there is no such thing as the “Chinese share market”. Any reference by media to the Chinese share market is a clear sign you are reading a poorly researched article. China has three share markets – Shanghai Stock Exchange, Hong Kong Stock Exchange and Shenzhen Stock Exchange – and they are all very different animals. Hong Kong is a far better regulated market than Shanghai, with a level of governance (listing requirements, continuous disclosure etc.) that is on par, if not superior to, western exchanges. Hong Kong is a market dominated by offshore and institutional investors (again, similar to western exchanges). Shanghai is dominated (80-90%) by retail investors. As a consequence, Shanghai is a far more volatile exchange. It is these retail investors (increasingly using gearing) that saw the Shanghai Exchange rally up to 150% over the last year (by comparison Hong Kong rallied up to 20%).

Because off-shore investors focus on Hong Kong, they were not materially impacted by the drop in the Shanghai market.

While there is no dispute that shares on the Shanghai market fell steeply for a few weeks, it is important to put this into context. The Shanghai market is measured by the Shanghai Composite Index. A year ago, this index was at around 2,200 and increased during late 2014 and early 2015 to around 5,200 in June (up about 150%). It then fell to around 3,500 before recovering to around 4,200. So, long term investors who bought stocks when the market was at 2,200 have almost doubled their money – so what’s the problem? Even with the Shanghai index dropping by 20% from its peak, why were there claims of investors losing EVERYTHING?

There were three main reasons investors lost money here: gearing, having a short time approach and a lack of diversification.

Gearing
Many Chinese investors took a highly aggressive approach to investing and borrowed up to 90% of the funds they invested – this is referred to as gearing (or margin lending). This means that shares only needed to drop by 10% before investors are forced to sell up and repay the 90% loan. By losing the first 10%, they lose everything. We do not subscribe to gearing in our portfolios.

Short term view
The Shanghai market is very young. It was only opened in 1990 and there is not a long history of investing. Local Chinese investors were making short term plays into long term investments. If they were prepared to take the knocks and hold in for a few years, they would recover their losses. They did not hold, but instead sold at the worst possible time. People who invested at the peak of the market had watched it double in six months and perhaps imagined the performance would continue for a little while. History tells us that equity markets out-perform every other asset class over the long term – but not always over very short periods. We only invest in shares if we have an appropriate investment time horizon to ride out any volatility.

Lack of diversification
The only way you can lose everything in a share market crash is to invest everything in that one market. I have sympathy for the Chinese investors who may not have had access to offshore investments and felt that investing everything they had in their local market was the best thing to do. This is totally contrary to our western mantra of don’t put all your eggs in one basket. We are fortunate to have access to a wide range of off shore investments, and try to maintain a maximum exposure to any one asset of 5% of the total portfolio. We also limit exposure to shares to a level that is appropriate for the amount of risk each client can accommodate.

What is the impact for NZ Investors?
NZ Investors will see very little on their portfolios. Our investors only have a small exposure to Chinese shares, and this is generally through Global Share funds that have a portion of their fund invested in China, or through the Premium China Fund which invests mainly in Hong Kong and Taiwan. These funds have performed well in the four weeks since the media started going mad on China. Broader International or Global share funds have returned 2.44% in the last 28 days, and the Premium China Fund is down -1.77% over the same period. (Calculated in NZ dollar terms net of Fund Manager fees, gross of tax).

So, as usual, the truth is far less exciting than the media would have you believe.

Did you ever read a headline that said “Share market investors enjoy acceptable returns over the long term”? No – that just wouldn’t sell papers.

If you would like more information about how your specific portfolio is performing, please contact your adviser.

http://www.investopedia.com/terms/a/a-shares.asp

http://www.premiumchinafunds.com.au/content/documents/monthly-factsheets/2015/pcf%20-%20may%202015.pdf