The Chinese equity market is becoming easier to access for foreign institutional investors with the recent removal of QFII and RQFII investment quotas. Increasingly, asset managers and pension funds are starting to foray into this market, attracted to the potential returns on offer. Therefore, understanding the dynamics of the market is a requisite for global and domestic Chinese firms alike.
One of the key differences when comparing the Chinese equity market to global developed markets is the dominance of China’s state-owned enterprises (SOEs). The definition of a SOE itself is not clear-cut. Some firms are entirely nationalized, while others are private enterprises but have provincial governments or municipalities as large shareholders. Using FactSet’s entity database to examine the CSI800 (the Chinese broad market index), we see that 79 firms have the national government as the majority shareholder, constituting more than 10% of the index by weight. In addition, three of the top 10 entities in the market are provincial or municipal governments. The government-related entities are highlighted in the table below.
The process of sorting through these relationships to define a SOE quickly becomes complicated. FactSet has partnered with Chinese data vendor FinChina to capture better insights into these companies. By FinChina’s definition, more than 60% of the CSI300 index (the Chinese large-cap index) by weight are SOEs.
This information raises several questions: Are Chinese SOEs less risky than their private counterparts? Is there some implicit guarantee factored into their valuations/returns that make them attractive for investors?
Comparing State-Owned Enterprises and Private Enterprises
Let’s start with a simple comparison of annualized returns of SOEs and private enterprises. As shown in the chart below, they are highly correlated. However, we can see that since 2017 SOEs have slightly outperformed private enterprises while private enterprises performed better in the period before 2017.
Digging deeper, there are certain periods over history when SOEs have tended to have more extreme returns, either positive or negative, compared to private enterprises.
The problem with this type of simple top-level return analysis is that it doesn’t account for any of the structural differences that exist between SOEs and private enterprises. For example, are SOEs more prevalent in certain industries? Do they tend to be larger companies?
With a simple comparison of weights in different Shenwan industries, we see that these kinds of tilts are prominent. For example, SOEs tend to dominate in the Banking and Food and Beverage sectors, which could impact relative performance.
Using a Risk Model to Adjust for Tilts
The only way to quantify how these different tilts impact risk and returns is to use a risk model. However, no commercially available models account for the effect of SOEs explicitly in their factors. Taking the advice of FactSet’s Russell Smith, we developed our own custom Chinese equity risk model. This model is like the major vendors’ models in that it is built by performing a cross-sectional regression based on common market, style, and industry factors. The primary difference is that for this regression, we first split the market into state-owned and private enterprises.
Our model allows us to analyze the exposures to factors to observe these characteristics in a standardized way. The chart below shows that within the CSI800 index, SOEs on average tend to have larger market caps, lower price volatility, and higher price momentum.
We can also observe the returns of the model factors. The chart below displays the returns of the SOE (blue bars) and private enterprise (green bars) market factors. We can see that when accounting for factor biases, private enterprises are indeed more volatile than SOEs. Interestingly, the rolling correlation between these factor returns tends to vary quite a lot through time. In most periods these two groups of stocks tend to be highly correlated; however, this sometimes breaks down, making it even more important to capture the differences between these types of stocks when assessing investment decisions.
Finally, as a quick test to confirm the importance of considering state ownership when analyzing Chinese stocks, we examined the residual security return from the custom risk model incorporating the SOE factor vs. a popular vendor model. In this type of test, a good model should have small residual return and should be normally distributed. You can see that the custom model tends to have smaller residual on average than the vendor model. Though the sample size is small, the custom model that properly captures the dynamics of the Chinese market performs better than the one that doesn’t capture the impact of state ownership.
As the Chinese equity market becomes more accessible to foreign institutional investors, it is important to consider the impact of state vs. private ownership on risk and return. Our analysis clearly shows that the two different types of companies have different characteristics (tilts) which must be considered when making investment decisions. To do this, it’s imperative to have the right data and a model designed to capture the nuances of the Chinese equity market.