China Equities: The Case for Long/Short Investing

In addition to reforms allowing shorting and margining, we believe there are three other features that make the China onshore market attractive to relative value investors like O’Connor:

• High retail participation: unlike mature markets in the West, Chinese retail investors represent a majority of equity trading volume: there are around 165m registered retail investor accounts and approximately 55m active² every day. The dominance of retail investors creates dramatic swings in momentum and valuation skews which can present unique alpha opportunities for relative value investors on both the long and short side of portfolios.
• Improving liquidity: the onshore market turnover is large and increasing. One goal of the recent reforms is to increase turnover on China’s exchanges – an important metric that should allow Chinese markets to attract flow from institutional investors. Over the past few quarters we’ve seen a steady increase in turnover in China, to the extent that it already exceeds turnover levels in both the rest of the Asia-Pacific region and Europe combined.
• Low analyst coverage: China’s markets are under-researched. Compared to the US, Europe or even much of Asia, there’s not a lot of analyst coverage of the China A-share market, particularly of mid/small cap companies. According to Reuters, almost 70% of companies greater than $500m market capitalization are covered by three analysts or less (see chart below). Additionally, only about 300 to 400 companies have English language research coverage, a small percentage of the overall market - which means the visible opportunity set for global investors remains small.

We believe that these dynamics will be prevalent over the long term; we foresee very little substantive change to them in the next three-to-five years. A good example is retail dominance in the market: while the influence of institutional investment capital is growing, we believe it will likely take years for it to overtake retail investors as a key driver of the market. We believe that there is a compelling window of opportunity to exploit this imbalance over the longer term.

We seek to generate attractive risk-adjusted returns with a low correlation to China equity markets by employing a low net exposure, relative value strategy focused on Greater China securities. Our approach is similar to traditional equity long/short strategies in the US and Europe, but customized for the uniqueness of Chinese market:

• Our focus is on Greater China equities, essentially China A shares as well as offshore listed China equities in Hong Kong, US, Taiwan and London (H shares, Red Chips, P chips, ADRs and GDRs). In terms of derivatives we are able to access index options, index futures, large cap single stock options, both listed and over-the-counter (OTC).
• In terms of sectors, our core focus is on sectors where we see the most opportunity. Currently these sectors are Financials, Cyclicals, Healthcare, Consumer and Technology/Media/Telecoms (TMT). We plan to expand coverage to other areas as opportunities unfold.
• Our stand-alone strategy is a carve out of a strategy running within O’Connor’s flagship multi strategy approach for the past two years.
• Our strategies benefit from UBS’s institutional governance oversight including independent risk control
• Unlike many of our competitors, we have analysts on the ground in mainland China, based in Shanghai:
• Looking back on when long/short funds opened in Japan, we saw many portfolio managers stay based in London or New York. We felt those managers were at a disadvantage - particularly when understanding the small- and mid-cap side of the market - because they lacked real relationships with management teams and industry leaders in the local markets.
• O’Connor has ‘boots on the ground’ in Shanghai, the intention being that the team captures valuable insights into the local markets. UBS Asset Management has a separate large, established presence and network in mainland China that we can also leverage to support our relative value strategy.