Diversification: Made in China

A popular Chinese saying goes something like this: ‘The best time to plant a tree was 20 years ago. The next best time is today. China’s entry into the World Trade Organisation in 2001 seeded a wave of globalisation and productivity gains as more and more global manufacturing was outsourced to China. Its USD 16 trillion economy is now second in size only to the United States and, according to the IMF, that gap is forecast to close over the next decade. China’s relevance on the global stage has never been more significant. The increasingly adversarial nature of the economic relationship between the world’s two largest economies simply reflects the natural competition among near peers. Regardless of which side, if any, one takes in this contest it is hard to ignore the influence that both these countries will exert on the global stage.

In this piece, we examine the growth of China’s economy and the concomitant increase in allocation to Chinese markets in investors’ portfolios. We highlight the often-overlooked Chinese commodity futures markets, demonstrating their size, recent growth and potential for further growth. We then focus on the diversification they can bring to portfolios, especially when traded systematically – even adding significant diversification to portfolios already containing other Chinese assets or other systematic futures strategies.

Before the pandemic, in late 2019, Greenwich Associates consulted[1] nearly 120 global institutional investors, spanning pension plans, endowments, foundations, sovereign wealth funds and asset consultants to explore the role China plays in global investment portfolios and how those allocations are likely to change over time. The high-level findings are that despite China’s economy and capital markets having grown to be the second biggest in the world, foreign direct investment remains miniscule and China is underrepresented in investment portfolios but this is an area of expected growth and increased focus.

Following on in 2020, Willis Towers Watson argued[2] the merits of a standalone equity allocation to China based on the economic size and importance of China on the world stage, and the diversification benefits of Chinese assets as well as attractive alpha opportunities. China’s inclusion in global indices coupled with growing openness to foreign investment allows for significant growth of Chinese assets in investors’ portfolios over the coming decade.

China’s rapid and robust recovery from the pandemic has been notable for its lack of the extensive stimulus measures seen in major developed economies. This resilience and potential decoupling of the Chinese economic growth engine has highlighted the rising relevance of China in the increasingly polarised investment landscape. The pandemic exposed many heavily linked and fragile global supply chains, in some cases in strategically important industries such as telecommunications or transport.

The escalating and enduring Sino-American strategic competition to secure self-sufficiency in vitally important industries of the future means that instead of investors needing to choose sides, a more forward-thinking approach might be to gain meaningful exposure to both these economies. China’s relative underweighting in most institutional portfolios has the larger potential for expansion. A recent example of this theme is evidenced by the world’s largest asset manager, BlackRock, who in May 2021[3] reinforced their house view which has strategically overweighed Chinese assets since late 2019.

[1] Please refer to ‘Crafting the optimal China allocation strategy; The asset owner’s perspective, Q2 2020’ by Greenwich Associates and Matthews Asia

[2] Please refer to ‘The merits of a standalone equity allocation to China, 2020’ by WTW

[3] Please refer to ‘Sizing China in strategic allocations. Portfolio Perspectives, May 2021’ by BlackRock Investment Institute

Chinese markets are becoming more open and accessible

To date the most accessible way for investors to participate in the ‘China factor’ has been via the equity markets. However, recent regulatory changes in China have widened the scope for foreign investors to be able to participate in other onshore Chinese assets. Following an announcement in September 2020, which took effect from November 2020, the Chinese regulator, CSRC, has expanded the scope of the QFI (‘Qualified Foreign Investor’) regime to permit direct trading in domestic Chinese futures among other things. Access to China’s domestic futures exchanges opens the possibility to deliver much needed diversification to investors’ portfolios via futures trading strategies – an area where Aspect has longstanding expertise, both internationally and in China.

In fact, given China’s dominance as both a producer and consumer of commodities, it isn’t surprising that the majority of these Chinese domestic futures markets are commodities. Commodity futures are traded across three exchanges, namely the Dalian and Zhengzhou Commodity Exchanges and the Shanghai Futures Exchange. Fan and Zhang produced a comprehensive review[1] of Chinese commodity futures markets. Their findings echo our practical experience: that momentum and term structure risk premia are persistent features of Chinese commodity markets. To make this topic relevant to foreign institutional investors we would like to highlight three key attributes of the Chinese commodity futures markets: accessibility, market size and potential portfolio impact.

Accessibility is the catalyst here. Without the expansion of the QFI regime this discussion would have been largely theoretical. However, at the time of writing, Aspect’s QFI licence application to directly access Chinese onshore commodity futures is awaiting approval from the regulator – a process that goes hand in hand with the commodity futures exchanges receiving approval for their contracts to be made eligible for trading under the QFI regime. This places Aspect at an advantage when Chinese commodity futures contracts become eligible.

The remainder of this piece focuses on the size of Chinese futures markets and what sort of portfolio impact a Chinese commodity managed futures strategy could have on institutional portfolios. Like traditional managed futures strategies’ ability to provide useful diversification and risk mitigation properties to growth assets, trend following strategies applied to liquid Chinese futures also offer diversification to both global risk assets like stocks and commodities but also specifically to Chinese equity markets. As the global economic centre of gravity gradually shifts towards Asia and as allocators continue to build out their exposures to China assets, they are also now able to participate in commodity assets that ebb and flow to the rhythm of China’s economy and in many cases are uniquely Chinese.

[1] Please refer to ‘Fan, John Hua and Zhang, Tingxi, The Untold Story of Commodity Futures in China (December 11, 2019). Journal of Futures Markets, Forthcoming, Available at SSRN: https://ssrn.com/abstract=3124223 or http://dx.doi.org/10.2139/ssrn.3124223’

How big are the Chinese commodity futures markets?

There are multiple ways to assess the size of the Chinese commodity futures markets. The simplest and most widely quoted in industry publications is that of number of contracts traded. On that measure Figure 2 ranks the top 25 commodity futures based on the number of contracts or volume traded during the full calendar year 2020. The market universe used comprises the 45 largest global commodity futures traded by Aspect (shaded in orange) and 40 of the largest Chinese listed commodity futures (shaded in blue). Before we notice anything else, the table is predominantly shaded blue – thus indicating that by sheer number of contracts traded, the Chinese commodity exchanges have dominated commodity trading activity in 2020.

Figure 3 ranks the same commodity futures markets by the volume traded measured in US Dollars. This metric seeks to adjust for the various lot sizes and gives us a more useful assessment of the size of the individual markets by looking at the economic value traded throughout 2020.

The table in Figure 3 is no longer a sea of blue but rather a finely balanced mix of orange and blue, as might be expected. Global blue chip commodity contracts such as gold and crude oil saw approximately USD 10 trillion of activity each during 2020. The next 20 or so contracts all traded between 1 and 3 trillion dollars and there the mix of global and Chinese markets is evenly distributed – highlighting the significance and size of the Chinese commodity markets on the global stage.

Finally, we highlight an interesting feature of the Chinese commodity futures markets in the table in Figure 4. When ranking the markets by the amount of US Dollar open interest, global commodity futures simply dwarf their Chinese counterparts. The low proportion of open interest relative to traded volume means lots of trading but less holding of positions for extended periods. This points to a market that is perhaps dominated by the shorter-term speculative behaviour common among retail investors, which is something that has been noted in academic papers, such as that by Fan and Zhang referenced earlier. This feature of Chinese commodity futures can create opportunities for well-constructed systematic investment strategies to harvest additional sources of return.

As relevant as the statistics from 2020 are it is useful to look at some longer-term trends and to provide context on the growth and development of the Chinese commodity futures markets. We do that in Figure 5 utilising the same universe of markets that we had used in Figures 2 to 4. The charts speak for themselves: by sheer number of contracts traded, Chinese exchanges have dominated global commodity exchanges for nearly a decade, yet the US Dollar volume remains below that of global commodity markets. However, the growth of Chinese commodity markets shows a near trebling in size over the last 3 years while global commodity futures markets growth was flat. In Q1 2018 Chinese commodity futures traded USD 4.5T compared to approximately USD 20T traded on global commodities. During Q1 2021, Chinese commodity exchanges saw USD 12T of volumes while global commodities still averaged around the USD 20T level. This comparative growth speaks volumes when it comes to assessing the economic relevance of Chinese commodity assets. The bottom chart shows the gulf in USD open interest between the two sets of commodity futures markets despite significant growth in Chinese open interest, again evidencing the different structural make up of market participants between the two camps.

What sort of portfolio impact can a China Futures Strategy have on an asset owner’s portfolio?

The final section of our article looks at the utility or portfolio impact investors can gain from allocating to a systematic trend following strategy applied to Chinese futures markets. At Aspect we have many decades of experience in developing and trading systematic futures-based strategies. Besides the evidence of futures markets having the ability to develop persistent and sustained directional moves, or price trends, which is not the subject of this discussion we do want to highlight the diversification benefits of Chinese commodity futures, both relative to global commodity futures but also at a higher level, relative to major asset class benchmarks.

In Figure 6, we select a representative sample of major global commodity futures as well as a selection of Chinese commodity futures and calculate their correlations since 2015. This time period includes multiple events and periods of interest for commodities both in China and globally: a commodity bear market in 2015; a boom and bust of Chinese equities in the middle half on 2015; the ratcheting up of the trade war between the US and China following Trump’s presidency in 2016; episodes of intense market volatility throughout 2018 as well as during and after the pandemic-induced global economic upheaval; and finally, a commodity centred reflation rally as vaccines provided the world with an exit route from the pandemic. In Figure 7, we look at the same selection of Chinese commodity contracts but we calculate their correlations to various major asset class benchmarks.

Whether we look at correlations between Chinese commodity markets and global commodity markets and major asset class indices the diversification benefits are evident.

Unique markets like Apples, Eggs, Bitumen or Polyethylene offer exposure to risk factors not captured anywhere else in investors’ portfolios. Even contracts such as Corn traded in Dalian versus Corn traded in Chicago are only 0.3 correlated over this period. This highlights that agricultural commodities that are produced and consumed in different parts of the world, especially those that are perishable and not easily transportable at short notice are likely to manifest significantly different price action. Another interesting observation is how diversifying Chinese commodity futures can be to major asset class benchmarks, including Commodities (Bloomberg Commodity Index) and even Chinese Equities (CSI 300).

Of course, this analysis implicitly assumes allocating to Chinese futures markets on a long-only basis, and one can do better than that. In fact, Aspect has been conducting research on Chinese futures trading for over a decade and Aspect’s onshore partner has deployed a systematic trend following strategy on domestic Chinese futures markets.

Summary

• The recent and future growth in China’s economy and the steady trend towards opening up of access to its markets has increased the country’s importance as a priority for investors’ portfolios.
• China’s on-shore futures markets have also seen significant growth in liquidity. The majority are commodities, many of which are not traded elsewhere, which means they represent an appealing and highly diversifying way to take exposure to Chinese markets and the broader ‘China factor’.
• Deploying systematic trend following strategies in Chinese futures markets can generate returns which are highly diversifying to traditional equity markets, including the Chinese equity market, and also to trend following applied to global futures markets. Aspect has several years’ experience applying trend following strategies in these markets.