In one way or another, China has come to dominate the conversation in financial markets.

Whether it’s insatiable Chinese demand for everything from steel to corn to luxury handbags, or its never-ending ding-dong with the US, or whether or not you believe its GDP figures, China seems to be a big part of most stories in the financial world.

And that seems to be the way its leaders like it. A recent report by the London School of Economics’ foreign policy think tank says China is set on pursuing globalisation, but with ‘Chinese characteristics.’

According to the report, globalisation is starting to fade with key figures like the US ‘decoupling’ as they aim for economic self-reliance, but while the US under President Donald Trump appears to be moving away from its long-held place as a global leader, China apparently wants to be seen as the rightful replacement.

Whether or not China does end being up being the new world leader, one thing is clear – you should care about China.

The country’s global influence is expanding rapidly, and in time it will enter our lives in the way all things Americana do today. But perhaps more importantly for investors, the returns today can be compelling – but only if you understand how China works, and you know what you’re doing.

BUMPER RETURNS
As an example of the returns on offer, take a fund like Matthews China Small Companies (B6T1MX2). It has returned more than 64.6% so far this year, has an annualised three year return of 27.3% and annualised five year return of 19.8%.

Most of the gains have come from some of its top holdings, which include technology stocks like Silergy, Jiajiayue Group and China Youzan. All of these companies have seen their share price double in the past year.

These types of companies are typical of what China is trying to become, a modern economy based on innovative businesses which are tapping into both the country and the world’s growing digitalisation, and catering to the growing middle classes both in China and abroad.

Let’s be clear, it’s important not to romanticise China too much and hold up its growth trajectory as the absolute, definitive model for the rest of the developing world, given its systematic crackdown on dissent and its alleged human rights abuses, which deserve to be recognised.

ESG CONCERNS
A significant number of its companies also have many environmental, social and governance (ESG) issues to resolve, particularly around environmental concerns and corporate governance.

A more belligerent attitude from the West towards China may also be a threat to growth, with the recent introduction of a new security law in Hong Kong drawing fire from the UK and US governments and leaders in Europe too. Trump’s recent attack on Chinese tech concerns like TikTok is just the latest example of this trend.

But it is a country with a clearly defined plan for growth and prosperity for its people, and the rapid expansion of high growth sectors like IT, pharmaceuticals, robotics, aerospace and automation are no accident – it’s all part of Made in China 2025, the strategic plan issued by Premier Li Keqiang in 2015. All of which makes this country fertile ground for investors.

China has young and therefore volatile financial markets, with many inefficiencies. This is after all is a country that in 1979 was poorer than Uganda. To put in another way, the London Stock Exchange was first set up in 1571. The New York Stock Exchange was established in 1792, while the Tokyo Stock Exchange originally began in 1842. The Shanghai Stock Exchange by comparison, started in 1990.

‘STOCK PICKERS PARADISE’
Combined with China’s support for its ‘national champions’ in the aforementioned growth industries, the inefficiencies in its stock markets have led investors to label China a ‘stock pickers paradise’.

‘China has some of the world’s most innovative companies, but it’s also is one of the most inefficient markets globally,’ says Roderick Snell, manager of Baillie Gifford Pacific (0606323). ‘It is a very good market for a stock picker.’

While more institutions are now coming on board as access opens up, Snell points out that China’s stock markets up until now have mainly been driven by retail investors, who on average tend to hold stocks for only two or three months. This gives an edge to professional investors who understand the country and how it works.

Despite the potential returns on offer however, you can’t just throw money at any old fund, and certainly not any Chinese stock, and always expect a decent return. There are still plenty of risks given the relative youth of China’s equity markets, and not all sectors of the Chinese economy necessarily have growth ahead of them. Picking the right fund is important.

For example, many Chinese equity funds available to UK investors have sizeable allocations to some of China’s big four banks, like Bank of China and China Construction Bank, which have shown virtually no share price growth at all in the last decade and have more challenges ahead as bad loans rise as a result of the coronavirus crisis.

BUBBLE WARNING
While just last week, Fundsmith Emerging Equity Trust (FEET) manager Michael O’Brien warned a ‘bubble’ could be developing in Chinese stocks, with the government through state-sponsored media encouraging a ‘healthy bull market’, as it has a tendency to do when it goes through a period of economic weakness.

But stripping out short-term noise, big opportunities do lay ahead if you pick the right sectors.

A sign of China’s rise, and a notable step forward in its financial reform, was the establishment of the Science and Technology Innovation (STAR) board on the Shanghai Stock Exchange in June 2019.

According to Anthony Wong, a Chinese equity portfolio manager at Allianz Global Investors, it’s these types of companies on things like the STAR board which will be one of key drivers of growth.

He says that one year since its launch, 140 companies have listed on the STAR board, raising a total of $31 billion, with the listings including companies in high tech areas including semiconductor manufacturing, artificial intelligence and biotech.

GROWING MIDDLE CLASS
It’s also impossible to talk about China without mentioning what’s underpinning its potential. One of the biggest investment stories to play out over the next couple of decades – and one which has almost all fund managers investing in the region excited – is the domestic consumption story related to the growth of China’s middle class, which is the largest in the world.

In fact a 2019 report from consultants McKinsey suggested that in the next three years, China’s middle class could total 550 million people – one and a half times the whole population of the US.

Adrian Lim, portfolio manager of Asia Dragon Trust (DGN), believes this is a story which could play out for the next two or three generations, and says it’s not just new economy companies that could benefit.

He explains: ‘It’s about catering to this growing Chinese demand for many things. So you have new economy businesses like Tencent, creating an ecosystem of applications, payments, gaming, email, etc. But also traditional businesses as well, like the whiskey and liquor makers.’

Indeed as the Chinese become more well-to-do and increasingly seek out the finer things in life, it’s not just areas like tech and healthcare which are set to see major growth. China is seen as the great untapped market when it comes to things like whiskey for example.

A colourless liquor called baijiu is currently the most popular spirit in China, consumption of which is seems to be de rigueur at parties or gatherings. According to analysis by global drinks market researchers IWSR, 1.2 billion nine-litre cases of baijiu were consumed in China in 2018—three times more than global vodka consumption, the next largest category.

Yet according to that analysis, the country only imported 1.3 million cases of whiskey for example in 2018, equating to 1,000 times less whiskey purchased than baijiu, showing the sheer size of the potential market gains available as tastes of the Chinese consumer change over time.

US TENSIONS SIMMER
One factor tempering all this excitement however is China’s tensions with the US. It’s important to note that this extends a lot further than some fight Donald Trump has decided to pick over trade.

As Lim says, ‘The tensions with the Americans would’ve always been there even if we had a Clinton administration, because here we’ve got two big powers trying to protect their sphere of influence.’

A quick way to see the friction between the two countries is to simply Google ‘Made in China 2025’. The first result that comes up is an article from a New York-based think tank, the Council on Foreign Relations. It immediately asks whether Made in China 2025 is a ‘threat to global trade’.

It’s no secret that both the US and China have long since had plans to extend their strategic reach beyond their own borders and even their own continents, and China’s current rise needs to be put in historical context going back to the 1940s.

Straight after the end of the Second World War in 1945, the US stood alone as an economic power. It accounted for 50% of the world’s GDP and effectively controlled 80% of the world’s money reserves.

For most of the intervening period in the last 75 years it has remained top of the tree, the world’s largest economy, a success story for prosperity epitomised by the American dream.

But now China, a country with communist values that capitalist America has always railed against, has risen to become the second largest economy, and with its GDP still growing at a significantly faster rate than that of the US.

Lim is among those who doesn’t foresee any meaningful resolution to the tensions between the countries anytime soon, but believes trade between the two could be ‘far more predictable, far less volatile’ if only they could ‘agree on a framework for how to compete.’

While Winnie Chwang, co-manager on Matthews China (B4627Y0), says the trade war has actually appeared to help China’s domestic economy, though stresses there will still be an ‘overhang’ on the economy overall.

She explains, ‘Late in 2018 when the trade war started, certainly we saw a lot of uncertainty from companies, there was a pullback in capital expenditure, businesses were less willing to invest.

‘But in 2019 there was more of an adjustment to a new normal, a realisation in China that the economy needs to move forward, and for example there was a lot of domestic companies in the technology sector doing what they could to become self-sufficient in double quick time.’

CHANGING PERCEPTIONS OF CHINA
While the tensions and their unpredictable implications rumble on, what has become clear is that over the next decade or two the world will certainly view China differently than it does today.

For years China has been seen as a country of imitation based on me-too business models, Wong says, and becoming the low-cost factory to the world. Turn over any cheap toy and the label ‘Made in China’ was ubiquitous.

‘It will, therefore, take a long time for this perception to change’, he adds. ‘The reality, however, is that things on the ground are already changing fast. China is moving rapidly from a culture of imitation to innovation.’

A sign of how things are changing, China now accounts for almost half the world’s patent filings. Wong highlights Alibaba, which became a household name as a pioneer in things mobile payments, cloud computing and e-commerce, and believes a lot more Chinese companies ‘will also become well known as global leaders in due course.’

Over the next 10-20 years China is widely expected to become the world’s largest economy. In line with that, Wong explains, China will have significantly bigger financial markets.

‘Indeed these will be an important step in paving the way for sources of funding for ‘new infrastructure’ growth areas, such as 5G networks, industrial internet, inter-city transportation and inner-city rail systems, data centres, artificial intelligence, and new energy vehicles.

‘As a result, China will likely play a much bigger role in people’s savings and investment portfolios than they do today.’

One last point worth considering, when thinking about the growth on offer in China, is that the country shouldn’t be seen simply as one big emerging market country. Instead, it has something of all development stages every country goes through.

As Lim explains, ‘Asia always goes through waves of this. At one end you have Singapore, South Korea, Japan – very developed. Then you have developing countries, like Thailand. After that you have frontier markets, like Sri Lanka and Pakistan, very volatile, the infrastructure is not as developed, there is not a clear path to growth.

‘We look at China as one country but it has all of these stages. The coastal regions are first world but go 100 miles in and you have all the stages of development. China’s growth story will take decades to play out.’

THREE WAYS TO PLAY CHINA
China is a big, diverse country with many different angles to it, and as such there are many different ways to play China.

INVESCO CHINA EQUITY (BJ04HS1) 641.7p

For those looking for good exposure to the country’s overall growth story from an active fund manager, but with the peace of mind of potentially lower volatility, Invesco China Equity (BJ04HS1) could be the way to go.

The fund has had a good year so far returning 27.38% year-to-date, while it has an annualised three-year return of 15.05% and annualised five-year return of 17.26%, and has a reasonable ongoing cost of 0.89% a year.

In the past five years it has only lost money once, in 2018 when it fell 9.22%, but this was still better than the 13.83% drop recorded by its MSCI China benchmark.

According to Citywire, the fund is the best over five years (the minimum period you should be investing) when it comes to maximum drawdown, i.e. the most a fund would have lost if bought and sold at the worst possible times, with a figure of just -15.6%.

Like a lot of funds, its top holdings include Alibaba, Tencent and China’s other big online retailer JD.com. But it also has decent exposure to China’s fast growing healthcare sector with stocks like pharmaceutical companies Jiangsu Hengrui Medicine and Sino Pharmaceutical, and medical device maker MicroPort. All three stocks, which are in the top 10 holdings, have either doubled or almost doubled since the start of 2019.

MATTHEWS CHINA  SMALL COMPANIES (B6T1MX2) $21.81

But if you’re looking to tap into the compelling, though riskier, growth story of the country’s rapidly expanding small and mid-caps, which are all part of the Made in China 2025 strategic plan, the aforementioned Matthews China Small Companies could be a good option.

The returns so far have certainly eye-catching, and going forward the fund looks like it could be well-placed to continue capturing that growth.

It definitely isn’t for every investor, particularly with a pricey ongoing cost of 2.25%, but for a patient investor who’s willing to take the rough times with the smooth, the potential long-term rewards could be compelling.

Three of its top five holdings are fast growing domestic tech stocks, and if reports are to be believed, this is an area of the economy which could gain further support from Beijing if US-China tensions – heightened by Microsoft’s talks to buy the American operations of TikTok owner Bytedance – continue to rise.

Despite the growth already enjoyed, the fund’s price-to-earnings ratio of 16.5 times – compared to over 20 times for larger cap China funds – also indicates the possibility of further growth ahead.

HSBC MSCI CHINA ETF (HMCH) 746.8p

China’s equity markets are both vast and relatively nascent, and so finding a good, reliable exchange-traded fund (ETF) to get a simple, broad exposure to the country’s stock market isn’t as easy as it seems.

But one option definitely worth considering is HSBC MSCI China ETF (HMCH), which has a total expense ratio of 0.6% a year. This ETF has been going significantly longer than some others in the market, and unlike some of the more needlessly complicated options simply tracks the performance of the MSCI China index.

It’s worth noting over 30% of the index is made up of Alibaba and Tencent, but other names you’d get exposure to include JD.com, Meituan Dianping – whose shares have gained over 150% since March – and finance giant Ping An Insurance.

What if you want to avoid China?

As tensions between China and the rest of the world rise, some investors may be nervous about putting money to work in the People’s Republic. However the wider Asia-Pacific region entirely, has favourable fundamentals including a youthful population and low financial services penetration.

Those interested in investing in the region without overloading on China exposure can find options among emerging markets-focused investment trusts, or in the Investment Association’s Asia Pacific ex-Japan sector.

In the latter camp are funds with less than 20% of their assets listed in China, and less than 30% in the increasingly troubled Hong Kong, which would limit your exposure to China.

They include BNY Mellon Asian Income (B8KT3V4), which had just 6.05% exposure to Chinese equities as at 30 June and 14% exposure to Hong Kong, according to FE Fundinfo. Also meriting mention is Jupiter Asian Income (BZ2YND8), the £719 million unit trust managed by well-regarded stockpicker Jason Pidcock.

As of the end of June, its China exposure sat at a reasonably modest 13.9%, although Hong Kong was significant at 20%, but balanced out by significant allocations to Australia, Taiwan, Singapore and South Korea. Top holdings do include China’s Tencent, although there is also exposure to Korean handsets-to-freezers maker Samsung Electronics and contract chipmaker Taiwan Semiconductor.

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