The Case for Factor Investing in China A Shares

Abstract

The Chinese A share market has recently attracted great interest from global investors because of its size and increased importance to the global financial market. The A share market has unique market characteristics and a regulatory environment that make it challenging for institutional investors. The article examines the efficacies of factor strategies by applying well-known equity factors in China A. It demonstrates that traditional factor strategies, with proper design, can deliver attractive risk adjusted return relative to the cap-weighted benchmark. From the authors’ review of the past literature along with their empirical study, they find that some characteristics of the Chinese stock market influence factor performance and factor strategy design. Notably, the traditional price momentum factor did not work in China A. Instead, a sentiment factor based on return reversal and analyst information can better capture local investors’ behavioral patterns. In addition to carrying out their empirical study, the authors look into a large body of academic research for economic and behavioral explanations of factor anomalies. Their findings provide strong support for factor-based investment strategies in Chinese A shares.

TOPICS: Analysis of individual factors/risk premia, factor-based models, style investing, emerging markets

Key Findings

• • The China A stock market has unique characteristics and a regulatory environment that influence factor performance and factor strategy design.

• • The authors review the academic research on factor investing, discuss the economic and behavioral fundamentals, and show evidence of the factor anomalies in the China A shares. They show that size, value, low vol, and quality factors can deliver attractive excess returns over the cap-weighted benchmark.

• • The study also finds that the traditional momentum factor failed to deliver positive excess return in the testing period. A sentiment factor is shown to robustly deliver excess returns and may more accurately capture the behavioral patterns that are unique to local market investors.