China is too big to ignore. But China’s equity markets and absolute returns are rarely considered synonymous by market observers so resolving this conundrum is a challenge for even the most sophisticated financial institutions.
Our work in China has further strengthened our desire to gain exposure to the market and led me to re-engaging with a very bright young academic who had spoken to me about his Theoretical Modeling for the Chinese Market at the height of the Global Financial Crisis in 2008. When we caught up, he told me about COES.
COES has been developed to deliver a strategy that captures the upside whilst mitigating the frequent market corrections which have devastated ‘buy and hold’ investing in China over the last 20 years.
Conceived during the aftermath of the global financial crisis, COES harnesses market timing and decades of successful investing in China to deliver a unique concept; two-stage, rules-based access to one of the world’s most exciting long-term opportunities for investors worried about volatility and significant drawdowns
The ability for the model to direct when to be “in’ the market (green) and when to be ‘out’ of the market (red) looks like a perfect ‘retro fit’ of data – but the model’s indicators have barely changed since our first conversation 10 years ago; at the time they were impressive but brought up to date and carried through the volatility of recent years, the charts remain truly impressive.
‘’Optimism is embedded in every equity investors’ DNA and there is an inbuilt fear of ‘missing out’ on upside moves, but markets need to pause for breath, often deeply’’. The project was undertaken in conjunction with Ned Davis Research Inc. (NDR) a world-class research hub based in Florida, USA that specializes in data programming, financial information delivery and systematic trading capability.
‘’Our relationship with Ned Davis extends back over 15 years indicating a high level of trust’’. ‘’The custom research team have been instrumental in ensuring sufficient rigour around testing our concepts and ideas, whilst ensuring the data utilised in our strategy is clean, consistent, reliable and secure. The result is a high degree of confidence in our process going forward’’.
Turning to the strategy itself, the entire COES investment process is underpinned by two independent proprietary models and the flexibility to move assets 100% to cash if required. A market timing model uses aggregate pricing data from the exchange to gauge the underlying health of the Chinese equity market at the index level and determines the allocation between equities and cash. The allocations are binary, either 0% or 100%.
‘’All we are trying to ascertain is whether the current environment is conducive to positive equity returns going forward. If the picture is bearish, we don’t need to be in there swinging for returns, it’s as simple as that’’.
Assuming the model is bullish (indicating a 100% equity allocation), a stock selection screening model selects the securities for portfolio inclusion.
‘’Liquidity is paramount. Experience has shown that idiosyncratic stock risk rises sharply as you move down the market-capitalisation curve in China’’. The strategy only invests in the 150-200 companies that comprise the MSCI China universe; this gives investors access to 85% of China’s equity market by capitalisation, whilst ensuring that all portfolio stock positions can be exited smoothly and with minimal slippage to the portfolio.
MSCI’s additional filters for potential inclusion along with conformity to Hong Kong reporting standards adds an additional layer of comfort when screening potential candidates.