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How Smart Beta Strategies Work in the Chinese Market

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Priscilla Luk

Managing Director, Global Research & Design, APAC

S&P Dow Jones Indices

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Liyu Zeng

Director, Global Research & Design

S&P Dow Jones Indices

EXECUTIVE SUMMARY

In response to the increasing interest in smart beta strategies in the Chinese equity market, we examined the effectiveness of six well-known risk factors—size, value, low volatility, momentum, quality, and dividends— in that market from July 31, 2006, to Nov. 30, 2018.

  • All the risk factors delivered absolute and risk-adjusted quintile return spreads, with the low volatility, value, and high dividend portfolios generating the highest risk-adjusted return spreads.
  • All the Chinese factor indices offered by S&P DJI, except the momentum index, generated absolute and risk-adjusted excess returns in the long run. The low volatility and high dividend indices delivered the highest absolute and risk-adjusted returns, while only the low volatility index had reduced return volatility and drawdown compared with the S&P China A BMI.
  • S&P DJI’s various Chinese factor indices behaved differently during up and down markets. The momentum index tended to perform better in up markets, but the low volatility, value, quality, and dividend indices had better returns in down markets.
  • Our macro regime analysis showed that most factor portfolios in China were sensitive to local market cycles and investor sentiment regimes.
  • Factor strategies can be useful tools for the implementation of active views on the Chinese equity market due to distinct cyclicality in factor performance.


FACTOR-BASED INVESTING IN THE CHINESE EQUITY MARKET

Smart beta strategies are gaining significant attention in the asset management industry, and the exchange-traded products (ETPs) tracking factor indices have shown significant asset growth since the end of 2008. Factor-based strategies are a category of smart beta strategies that target specific risk factors. They have characteristics of passive investing, such as rules-based construction, transparency, and cost efficiency; they also share features of active investing in that they aim to enhance return and reduce risk compared with traditional market-cap-weighted indices.

Single-factor indices are constructed to capture a specific risk factor. They exhibit distinct cyclicality in response to a changing market environment, which also makes them ideal tools for the implementation of active views.

In China, we observe increasing interest in factor-based investing in the equity market, although it lags the U.S. and some other Asian markets (like Japan). Dividend products still dominate the Chinese factor-based ETP market.

In this paper, we examined the effectiveness of six well-known risk factors (size, value, low volatility, momentum, quality, and dividend) in the Chinese equity market and the behavior of these factors under different market regimes.

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