Hot China causes conflict between discipline and performance

The play on the China theme, with massive inflows into China’s financial markets, made investing in China increasingly difficult for S& P-rated fund managers in 2006, says Standard & Poor’s Fund Services, the leading provider of qualitative fund management ratings.

For EM Asia managers investing in China, the strongest returns were achieved by the least liquid classes of shares, notably A and B - which strongly accelerated towards the end of 2006 - while Red Chips and H shares recorded strong though less sparkling figures. As Roberto Demartini, Standard & Poor’s lead analyst points out, “While the valuation differential between some of these classes of shares is still wide, the scarce liquidity of A and B shares coupled with the strongly increased assets under management have made it very difficult for the fund managers interviewed to invest in this segment of the market over the review period.” This makes a short-term convergence between the prices of the different classes of shares more unlikely and has resulted in the exposure of the S& P-rated funds to A and B shares to be in most cases kept below 10% of the portfolios.

Both Martin Lau at First State and Eddie Chow at Franklin Templeton felt the performance of the market could be summarised in one word: momentum. Investors rewarded indistinctively stocks of very varied levels of quality and valuations, and as Martin Lau highlighted, investors focused on the China growth story and bought anything that was somewhat related to that. As Demartini notes, “This largely explains why the majority of rated funds underperformed their index benchmarks, as most funds were flooded with inflows during strongly rising markets, making it difficult to maintain a disciplined and valuation-aware approach while keeping focused on the market.” Therefore, being disciplined in most cases meant underperforming the benchmark.

Among the funds that S& P covered, a notable mention goes to Martin Lau, who has managed to maintain a pragmatic approach, by participating in some IPOs while remaining true to his investment criteria focusing on quality. On the other hand, Louisa Lo at Schroders preferred to focus on the long-term and on valuations, hence the weaker returns in 2006 followed by a very promising start of 2007.

The picture is also very similar in India, although the market rise has been driven by the larger caps while mid and smaller companies have lagged. Here, JPMorgan India and Franklin Templeton India were among the few winners.

The outlook for 2007 is one of cautious optimism and of focus on fundamentals and valuations. Most managers have welcomed the sell-off started in February 2007 as a healthy way to correct valuations that in some cases were unjustified. They are confident that the long-term prospects for the region are not going to be affected by what seems to be a temporary dip of the markets.