A low-cost passive approach to Chinese equities is a robust investment strategy, according to a recent commentary piece by ETF provider Vanguard.
A low-cost and highly diversified indexing strategy is a good approach in any market, including China.
While the volatility and inefficiencies of the Chinese equity market – inherent in most emerging market countries – lends itself to opportunities for active investment management, Vanguard highlights that picking winners can be difficult over the long term.
The asset management giant proposes that a low-cost and highly diversified indexing strategy is a good approach in any market, including China.
A zero-sum game
The market is the sum of the cumulative holdings of all investors, and the aggregate market return is equal to the asset-weighted return of all investors, notes Vanguard. For every outperforming position, another investor must take the opposite side of that position and underperform – and that is before fees. When costs are included, more investors are expected to underperform than outperform the market. Investing is a zero-sum game: that is the theory which underpins the case for low-cost index investing.
Due to this 50/50 nature of the zero-sum game, Vanguard recommends that investors control costs to reduce the drag on performance, and they must be aware of the challenges of outperformance once costs are considered.
The benefits of diversification
Investment strategies that have a concentrated range of focus, or are less diversified, will typically be higher risk. The chart below displays the returns and volatility of all equity funds with a China mandate, compared with the returns and volatility of the FTSE Total China Connect Index (a benchmark which covers large- and mid-cap Chinese equities in all major share classes listed in or outside China).
Source: Vanguard.
It shows that 54% of the equity funds underperformed the broadly diversified FTSE Total China Index on a returns basis, and of the funds that outperformed, 51% were more volatile than the index. Those that outperformed also exhibited a high dispersion in returns. Over the five-year period ending 31 December 2017, over 74% of the equity funds had total returns +/-5% from the benchmark. According to Vanguard, the results show that the index delivered much more predictable returns and eliminated the exposure to manager risk.
Persistent outperformance isn’t easy
Although 54% of the equity funds underperformed the benchmark, 46% of managers did beat it; but for how long? If experience shows anything, it’s that past performance is no indication of future performance.
The next chart by Vanguard shows the returns of the top quintile of performers over a five-year period and also shows their performance over the next five years. Over 50% of those previously top-performing managers fell to the bottom two quintiles or liquidated, while only 11% actually stayed on top. Persistent outperformance is no mean feat.
Source: Vanguard.
Passive becomes an attractive prospect
These challenges are not unique to China. It’s hard to beat the benchmark in this zero-sum game. The broad exposure and low costs offered by passive investing make it an attractive prospect for any portfolio. This is where ETFs come into play, providing investors with a low-cost, efficient, passive investment vehicle.