Recently, I have been looking at the situation surrounding Chinese stocks. Each time, I have concluded that buying individual equities could be too risky considering the uncertain political environment.
The only way to calculate the intrinsic value of a security is to analyze its long-term cash flows. If we cannot calculate how much cash a company will be earning in five or 10 years due to uncertainty, then it is impossible to value that security.
Having said that, while I have concluded that individual Chinese equities may be too risky, I am generally optimistic about the outlook for the overall Chinese economy. I think it is highly likely that the economy will only grow over the next few decades, and I do want exposure to this.
The approach I have decided to use to gain exposure to this theme while limiting my exposure to individual companies I do not particularly understand is buying a fund.
However, I have not bought a passive fund, which is usually the avenue I would advocate. Unlike the U.S. equity market, which is highly efficient, Chinese equity markets are nowhere near as efficient. Equity market movements are usually dominated by speculative behavior, leaving a gap for active patient managers who use a rigorous approach for finding opportunities.
This is why I have chosen an active investment fund to build exposure to the region.
Active investment fund
Baillie Gifford (Trades, Portfolio) China Growth Trust PLC's (LSE:BGCG, Financial) goal is to outperform the MSCI China All Shares Index by at least 2% per annum over rolling five-year periods.
Over the past five years, it has achieved this aim, with the B share class returning 19.2% compared to the index return of 12.1% per annum. It has an annual management charge of 0.77%, which is expensive but not particularly so considering other actively managed funds.
The fund uses a concentrated approach. It is aiming to own a portfolio of between 40 to 80 stocks. At the end of July, the top 10 holdings accounted for 44% of assets. The most significant investment, making up 9.3% of total assets, was Alibaba Group Holding Ltd. (BABA, Financial). The second holding was Tencent Holdings Ltd. (HKSE:00700, Financial), making up 8.4%.
I will admit this is a high allocation to these stocks considering that I have said I do not want to invest in them directly. However, outside of these holdings, the portfolio is well diversified. Around 32% is invested in consumer discretionary stocks, 17% in health care equities, 14% in communication services and 10% in industrials, with the rest spread across different sectors. With exposure to all corners of the market, I would say the portfolio is diversified.
Put simply, this fund provides me with a way to gain exposure to a region I believe will do well over the next several years without adding an extra layer of risk. That layer would be me choosing the stocks myself.
Of course, I am exposing myself to the risk that these managers don't continue to outperform. That is a genuine risk, and one that I am well aware of. Still, even if these managers were to match the market, I think the rising tide of China's economy will lift all boats.
No investment is risk-free, but I think the balance of risk and reward is skewed in my favor here, considering the challenges, risks and uncertainties of finding investments in China. There are some downsides to investing in the region with this method, but there are plenty of advantages as well. If the investment does not work out, I can always sell up and move on to another opportunity.
