Episode #296: Jason Hsu, Rayliant Global Advisors, “As Investors, We’re Always Looking For Uncorrelated Sources Of Return”
Guest: Jason Hsu is the founder and chairman of Rayliant Global Advisors. Prior to his current role, Jason was the co-founder and vice chairman of Research Affiliates.
Date Recorded: 3/3/2021 | Run-Time: 51:11
Summary: In today’s episode, we get an update from Jason on the Chinese stock market and hear how it differs from the U.S. Then we talk about his new ETF, which gives investors a way to allocate to China A-Shares. He explains why the A-Shares are a great place to seek outperformance due to the large amount of retail involvement. Jason then addresses some of the most commonly cited risks for investing in the Chinese stock market, including accounting issues and the presence of so many state-owned-enterprises.
As we wind down, Jason gives his take on the recent developments with Ant Financial and Jack Ma.
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Links from the Episode:
- 0:39 – Intro
- 1:30 – Welcome to our guest, Jason Hsu
- 1:35 – The Meb Faber Show | Episode #52: Jason Hsu, Rayliant Global Advisors, “This Is A Market Where The Average Human Tendencies Are Precisely The Wrong Thing To Do”
- 2:22 – Early lessons while building Rayliant
- 3:28 – Understanding Chinese regulators
- 5:27 – Recent trends in Chinese markets
- 7:19 – Onshore versus offshore shares
- 9:55 – China’s increasing trading volume and expected growth
- 11:22 – The gap in indexing and benchmark products in China
- 12:24 – The profile of the average Chinese retail investor
- 13:05 – Rayliant’s active ETF product
- 15:08 – The retail focus on return chasing
- 16:52 – Why it’s important to track management integrity
- 19:16 – Analyzing safety indicators
- 20:08 – Should Investors Allocate More to China A Shares? Putting Common Arguments to the Test (Wool)
- 20:48 – Building databases in China
- 24:13 – Finding opportunities in state-owned enterprises
- 26:49 – Rayliant’s approach to portfolio composition
- 29:00 – Widely dispersed Chinese stock valuations
- 30:36 – Understanding the true story behind Chinese banks
- 33:17 – Separating China from other emerging markets
- 35:11 – The problem with the China shares included in MSCI indices
- 37:39 – Rayliant’s future plans for bringing additional funds to the US
- 39:52 – Our psychological bias around a bond portfolio
- 41:09 – Why Jason anticipates the renminbi to strengthen
- 42:57 – Why the Ant Financial IPO was stopped
- 45:05 – Understanding the US-China dynamic
- 47:51 – Jason’s thoughts on 2021 market performance so far
- 49:01 – Teaching during a pandemic
- 49:48 – Learn more about Rayliant; Rayliant.com; Twitter @Rayliant; LinkedIn; Rayliant Articles
Transcript of Episode 296:
Welcome Message: Welcome to the “Meb Faber Show” where the focus is on helping you grow and preserve your wealth. Join us as we discuss the craft of investing and uncover new and profitable ideas, all to help you grow wealthier and wiser. Better investing starts here.
Disclaimer: Meb Faber is the co-founder and chief investment officer at Cambria Investment Management. Due to industry regulations, he will not discuss any of Cambria’s funds on this podcast. All opinions expressed by podcast participants are solely their own opinions and do not reflect the opinion of Cambria Investment Management or its affiliates. For more information, visit cambriainvestments.com.
Meb: What’s up, everybody. Great show today with a returning guest. He’s the founder and chairman of Rayliant Global Advisors, where he offers products to transform the investment ecosystem in Asia and beyond. In today’s episode, we get an update from our guest on the Chinese stock market, ways it differs from the U.S. Then we talk about his new active ETF to provide access to American investors in Chinese A-shares. He explains why the A-shares are a great place to seek out performance due to the large amount of retail involvement. Our guest then addresses some of the most commonly cited risks for investing in the Chinese stock market, including accounting issues and the presence of so many state-owned enterprises. Be sure to stick around till the end to hear our guest take on the recent developments with Ant Financial and where in the world is Jack Ma. Please enjoy this episode of the Rayliant Global Advisors, Jason Hsu. Jason, welcome to the show.
Jason: Meb, glad to be back.
Meb: It’s been three, maybe four years since the last time we had you on. Listeners, we’ll link to it in the show notes. I think last time you were in Taipei. Does that ring a bell?
Jason: That’s right. That is correct. I was actually speaking from my apartment in Taipei.
Meb: Where have we found you over the last few years and where are you now?
Jason: I’m usually either in the States or somewhere in Asia, but right now at this moment in time, I’m in Irvine.
Meb: Right down the road. Well, hopefully, we’re not too far away from doing this in person. I miss those. Maybe, according to the government, a couple of months away. We’ll see. What’s been going on? Last time we talked, you were just starting your new company, Rayliant. Walk us through the last couple of years. What’s been going on in markets? What’s been going on with you? Catch us up.
Jason: Last few years, we’ve been building our presence in Asia, specifically onshore to China, launched a number of ETFs in China and in Hong Kong, gathered about $2 billion across five different ETFs. Learned a lot about what it’s like doing business in China. Learned a lot about that market and realized it is not just the U.S. may be a few decades behind, but it is quite idiosyncratic, very, very unique, the culture, the language all makes what we come to understand, is markets quite different in China. But it’s been a lot of fun, a lot of learning. The team’s loving it. We’re now taking all of that and bringing it back to the U.S. So that’s what we’ve been busy doing the last few month, is to bring our chatter products to the U.S., and then we’ll be launching a number of products over the next few years.
Meb: It’s exciting. Congrats. And we’ll get to the one that you launched here a couple months ago. You mentioned a note I would love to hear you expand on that a little bit. What would be the differences that…? I’ve actually never been to China. Been to Hong Kong pre-turnover. What would be some of those differences that would surprise me or others are ones that you found in the business world to be a little different than perhaps over here?
Jason: First and foremost, when we think about Chinese policymakers and regulators, we tend to have a fairly negative perspective and we look at it more from a communist party, an authoritarian party versus the U.S. which is, you know, democracy-based. And that’s really not the right lens. What I have found is you really want to think of Chinese regulators versus the U.S. regulators as kind of the tiger mom versus a Montessori, perhaps. It’s very paternalistic in China. So when you talk to regulators, they’re always thinking about, “Well, what is for the greater good and how to regulate and bring about that?” And there’s very little trust in the market, leading to the greater good. For example, you think about the U.S. stock exchange, right? It’s very much a buyer be aware, consenting adults making trades, so no one gets to complain. But the exchange in China, they feel like it’s their responsibility to only list the companies. So in the listing process, they actually come in almost as an independent underwriter and conduct independent due diligence. So it’s actually much more difficult to get listed in China because the exchange is just terrified of listing a firm that would eventually blow up or drop a lot in stock price.
And then in addition to that, once you get listed, the exchange will constantly launch investigations. If they discover that your accounting doesn’t make sense, what your CEO is saying doesn’t line up with what you’re filing with the tax authority, doesn’t line up with what you’re filing with the exchanges, there’s almost like an army of sell-side analysts working at the exchange trying to dig up dirt and finding out whether firms are behaving well or behaving badly. So that’s probably one of the biggest differences that I see between U.S. and China regulators and that sort of cascade into almost every aspect of doing business and managing money in China.
Meb: What’s been going on in Chinese markets the last few years since we last talked? Any general comments? And, of course, there was a little pandemic in between. What’s the update?
Jason: If you think value has been taking in a chin in the U.S, let me just tell you, last year, growth in China outperformed value by 35%. If you think you can earn a value premium of 1% to 2% a year, right? Basically last year in China, you just lost about 15 years’ worth of value premium that one could gather and earn. That’s a market that is just volatile. You can call it a bubble, you can call it irrationality. Can certainly run wild and deviation can be larger and longer than you have capital to hold still. So the last few years it’s been certainly a very growth-oriented frothy bubble market in China, moreso than even in the U.S., in addition to that COVID pandemic, you know, the market reaction around that event, in China was very muted. In the U.S. you saw initial decline down as far as 30% followed by kind of gradual climb before making new highs. In China it was a tiny blip downward and immediately the market’s making a new high. And it speaks to the increasing lack of correlation decoupling between Chinese capital markets from certainly U.S. capital markets, if not from the global capital markets. In some ways, that’s a good thing, right? Because I think as investors we’re always looking for uncorrelated sources of return and we’re almost running out of them as the world’s become so correlated.
Meb: I know this is basic stuff, but give us the quick overview, again for the listeners who may not be as familiar when they hear about China. You know, they hear about, they’re including some indexes, they’re not including some, there’s some A-shares, there’s some H-shares. There’s things listed. Give us a quick summary of the way it works. And if I recall, the last time we chatted you were saying it tends also to be a lot more on the volume side of retail-driven market as well. Is that still true? Give us just kind of the quick overview of how the Chinese market is different than what we think of when we think of the U.S.
Jason: So when people talk about, you know, Chinese equities, there are onshore versus offshore, which is certainly something you don’t see in the U.S, right? So onshore are referred to as the A-shares. These are shares that are traded on either the Shenzhen Stock Exchange or the Shanghai Stock Exchange. And then you have the offshore shares. These are things that are traded in Hong Kong or traded primarily say U.S. as ADRs. And the firms that trade onshore versus offshore are often quite different. So take, for example…and most of us are probably more familiar with many of the ADRs. So take Alibaba and also take many of the Chinese firms that’s sort of blown up and gotten China a black eye and bad reputation and has led to the U.S. imposing the Hold Foreign Company Accountable Act, really targeting Chinese firms that seem to have suspect disclosure practices.
And that’s actually much more offshore, much more U.S. ADR. Whereas if you then look at, say, the Hong Kong-listed shares, they’re generally state-owned enterprises. So they’re like the biggest banks that on the first day of listings are already at $400 billion in size. They’re the biggest telcos. And the reason is Hong Kong has always been the gateway to China and viewed by the Chinese government as the face of the country. So they’ve only approved just the biggest, most stable, most intimidating enterprises to be listed there. And then you’re not surprised these are, you know, often big, giant state monopolies with strong cash flow and then unlikely to grow very much, but certainly unlikely to have any kind of risk event.
And then that leaves you with all the onshore, which is where really all of the interesting actions are…a lot more firms, lot greater sector exposures that you can get access to, much more significantly. So non-state owned, so, you know, private enterprises. But what’s more interesting is onshore is almost entirely retail trades. It’s 85, 90% retail traded, whereas the Hong Kong and the U.S. ADR, you’re not surprised, they’re going to be overwhelmingly institutionally held and institutionally traded. And so in terms of alpha opportunities, you imagine the onshore Asia would be more alpha-rich because you have participants who are just not as sophisticated.
Meb: And so as far as the complexity, give us the overview, I think a lot of people rightly so would make the assumption that Chinese stock market will probably eventually become the world’s largest. You know, it’s not currently. U.S. is I think, half or a little over half. Give us the overview of what it looks like. Any differences, whether it’s sector composition, do most investors in China and here currently simply allocate through market cap weighting, indices. How do most people go about it today?
Jason: In China, today there are roughly 3,800 liquidly-traded stocks that are included in kind of the key indexes, you know, covering large to the small caps. Now, you compare that to U.S., right? U.S. has been shrinking, right? U.S. used to be, you know, closer to 5,000 and it’s really closer to 3,200 today. So while U.S. is sort of shrinking down the public markets, as many things have gone more private and most of the money have sort of concentrate toward the top-end of the index, now China’s sort of doing the opposite. There are just more stocks being listed and it is quite very, very liquid down even on a small-cap range. And so you now have more stocks liquidly-traded in China and certainly, the trading volume is close to U.S. So that will be kind of a little bit of where China is, is they’re catching up to the U.S. But in terms of capitalization, you’re right. It’s only half of what U.S. is today. Now, the projection is it will likely overtake over the next 10 years.
Meb: Wow. Within the 2020s.
Jason: Yeah. Because more of these unicorns are coming online whereas most of the U.S. companies have kind of largely gone listed, but there are a lot of these mega unicorns in China that are just seeking a rare opportunity to be listed, certainly with price appreciation and more firms listing. And obviously with the GDP potentially overtaking the U.S. over the next, say, 5 to 10 years. The capital market overtaking the U.S. is a significant reality. And in terms of investors in that market, though, the concept of indexing or a benchmark or even thinking about cap weighting is very foreign. Most investors just aren’t there yet. So there are very few benchmark products in China. Certainly the whole idea, you need to benchmark your manager, you want to outperform the index. Now, that’s a foreign concept that not many, even some in the institutional world don’t quite hold it.
Meb: I was laughing as you were talking about the number of companies because in my head, I’m like, “Well, if Silicon Valley keeps launching 1000 SPACs a day here in the U.S. will eventually catch up because there’ll be no more private businesses with the amount of SPACs going on.” So are most people always kind of like old school stock-picking or they’re just amassing a portfolio of stocks based on whatever their approach may be?
Jason: The funds industries is actually tiny relative to the kind of wealth that sit with the discount brokers inside China. So it’s very much like the 70s, maybe early 80s in the U.S. where, you know, the brokers are dominant in terms of wealth management, I just call it, for lack of a better word. So individuals primarily trading aggressively, often day traders, I mean, they probably hold anywhere from four to six stocks and turn over a couple 100% a month. That describes your average retail individuals. It’s not really saving for retirement. It’s more social gambling right now.
Meb: All of the lead-in seems to make the case, there’s a lot of opportunity to be investing in China. Talk to us a little bit about your new fund. You put out a new fund here. And feel free to weave in any of the ones you’re managing abroad, but would particularly like to hear the methodology behind a new strategy launched just a few months ago.
Jason: At the highest investment philosophy level, this is very much about giving you exposure to an interesting, uncorrelated beta that currently doesn’t live in a lot of investors’ portfolio. And then, of course, tapping into that massive alpha reservoir provided by really these unsophisticated gamblers who come to the market really for social gambling than for long-term investing. So the beta’s interesting and if you tag on the alpha opportunity, we think there’s a real opportunity for managers and also global investors. So what we brought out in the U.S. is an active ETF. So basically it’s not tracking in, in that it really is just our multi-factor quantitatively driven China, Asia’s active strategy just in an ETF chassis. And today, you know, with how slick the whole ETF ecosystem is, it’s cost-effective. It’s very easy. It dominates a mutual fund, the chassis. So we thought, you know, why not bring it out in the ETF format and then still be able to be fully active.
In terms of what drives the alpha profile for the fund, a lot of it is just really targeting what are the persistent behavioral biases that you can identify in China? So some of it will be fairly familiar to you. It would be similar to many of the things that, Meb, you have in your own strategies. I would call it anti-growth. Works really well in China. And it’s because, you know, in China, it’s one glitzy shiny theme after another and they never pan out well. So if you just systematically avoid things that are trading at 500 times earnings, you’re generally going to do well and participate in the true growth of the Chinese economy. A lot of it is avoid what the retailers are buying and participate in what the more-educated, more-informed long-term buy and hold institutions are doing in China. So avoiding shares that are heavily held by retail, you’re going to do well. You’re going to participate in the China growth a lot better.
Meb: What is the retail attracted to? Is it just kind of the obvious momentum names of what’s doing well? Is it like the big tech companies?
Jason: Retail’s often attracted to what’s done well recently. So there is an unbelievable return-chasing that’s amplified by the entire ecosystem. So if you have a brokerage account, right? The broker’s constantly texting you, your phone’s constantly ringing or reminding you, you know, what’s the highest advancer today, what’s the best performing stock sector. And, of course, the mutual fund companies in China are different than the U.S. There’s not a lot of sort of core offerings. Most offerings are very thematic, very sector-oriented. So the best-performing sectors would have, you know, lots of new funds and ETFs being launched around that, all which just amplify return-chasing. So it’s very much a short-term momentum market, thematic market, growth-oriented market for retail trading. And, of course, those don’t produce long-term results, right? So if you look at the retail underperformance versus the market, I think in the U.S. it’s, you know, something like 4% or 5%. In China it’s closer to like 12%, maybe 14% of sort of the retail performance versus a buy and hold of the market.
Meb: That’s significant. I was smiling as you were talking as I was looking over your fact sheet because as you talk about some of these quantamental approaches, you know, you have the traditional value, quality and then a couple of columns for management team integrity, which I don’t know if I’ve seen on a traditional U.S.-based quant ranking and then a smart versus dumb money score and then a safety score. Talk about how they plan. I feel like most of the listeners would be familiar with traditional value composite sort of ideas, quality. What are some of these other metrics or ways to think about name inclusions into the portfolio?
Jason: The integrity of the business operator is huge. People are not crazy to suspect that Chinese accounting numbers may not be as trustworthy and reliable. So if you’re going to build a model, DCF or otherwise using those numbers, you probably are going to come up with numbers that just aren’t very useful. That suspicion is not crazy. It is actually true. So we did a study where we basically looked at the reported accounting numbers and you can clearly see that, you know, Chinese companies really try very, very hard not to report a negative number. It just doesn’t look like a normal distribution, like firms seem to never lose money. So it’s quite abnormal. And we know that’s first sign of some kind of aggressive earnings smoothing or earnings manipulation.
So, in fact, we find overwhelming evidence supporting that fear. But if you look even deeper, what’s interesting is substantial majority of firms that manipulate earnings actually manipulate them downward, not upward. That’s truly bizarre, right? If you’re going to fudge accounting, you want to fudge it upward so you get a higher stock price so you can pump and dump, right? But no, in China, it actually works the opposite. And, again, this goes back to what I mentioned early on in the show about paternalistic regulation, because in China, if you lose money as a company, the exchange come and kind of slap you around a little bit. If you lose money again, now the restriction plays on the trading of your stock, your stock can’t be margin. If you lose money again, they begin to prepare you for delisting. So firms are terrified of that. So they try to not to report a loss. What they do is when they are very profitable, they under-report profits.
So they pocket, they have reserves so when they have a bad year, they can use the reserve to smooth earnings. And if they have a bad year where they have to report a negative number, they’ll just report an enormously large one, way more than the amount of money actually lost, again to build a reserve so that it would avoid two consecutive negative years. And so once you recognize that and know how to restore the actual income statement and balance sheet, you can just model a lot better. When I say integrity of management, you’re going to basically figure out is the management fudging accounting, trying to pump and dump, in which case, very low integrity and there are lots of other issues, or are they just trying to comply with perhaps a somewhat naive set of regulations and barely are being quite concerted as business operators?
Meb: What’s the safety sort of metric come into play? Is that similar to quality? Is it sort of a balance sheet issue? Is it more of a sector, things you avoid? What’s the insight there?
Jason: Yeah. So when we look a variety of sort of safety indicators, a lot of it is leverage. In China, you have two types of growth firms. One grows because they’re literally, you know, coming up with a good idea and selling it to 1.6 billion consumers, right? That’s wonderful growth when you can sort of, you know, scale that up. But there are a lot of old uninteresting manufacturing with no brand, no market share who’s growing just because they’re leveraging, they’re just applying leverage. And so you end up finding a lot of growth firms that oddly enough are heavily leveraged. It’s something you never see in the U.S. And then that will be, say, a very major risk flag. Other safety indicators would be just related to the skewness of the return distribution related to how highly correlated and how high beta they are with the broad market.
Meb: You have a good paper out called “Should Investors Allocate More to China A-Shares? Putting Common Arguments to the Test,” that I thought was a really good paper. And along the same lines of this manipulation sort of quality metrics management integrity, you mentioned on the banking side you got to always read the footnotes and cleaning the data. That’s something that I think people think about here but not as much, maybe a footnoted blog and in forensic accounting, but not as much. What’s the experience been like in China? Is that something that’s like a necessity that is pretty widespread? You see some crazy stuff? Is it something you can just clean with a quant database? How’s that work out?
Jason: I mean, building databases in China are both interesting, frustrating, but also super exciting because, first of all, there’s just lots and lots of data, right? Like in the U.S., oftentimes, you don’t have data because, you know, we didn’t use to keep track of that much stuff and it was much more expensive back then. China really began as a liquid capital market 15 years ago and so everything was modern and lots of data sort of kept. It’s very clean, it’s very easy to access. So there’s just a lot of data. And second of all is, you’re probably not surprised, China just loves collecting data, anything and everything that can be collected is collected and gathered. And they’re not too strict about data privacy. So a lot of that is actually made available for research, for studying, for purchase, for web scraping. So you can build lots and lots of interesting data and it really comes down to, can you make sense of it? Can you create the value out of it? Can you analyze it? Because a quant, it’s just a wonderful laboratory, right? This is a great place to study data and then make that data useful.
And this is like the second part that’s exciting. The U.S. has a lot of data as well. Probably not as much as China, but there’s still, you know, lots of data and it’s longer data, right? But the bad news there is, there are too many quants in the U.S. So we study all the same data to death, right? And we’re just competing against each other to the degree that there’s almost very little alpha that can be squeezed out of that data, right? That lemon’s been squeezed pretty dry. You know, a lot of the forensic accounting, a lot of analyzing all sorts of ratios doesn’t do anything for investors in the U.S. anymore and we almost don’t teach them anymore in our accounting or our investment class because they just don’t work. Not because they don’t make sense, but because everyone who thought they made sense used it to trade and so no more alpha. But in China, these things work really, really well because the average investor is a retail person who doesn’t really use a computer and doesn’t understand accounting. So as a quant, having that data and acting on data is very powerful and very profitable.
Meb: It’s not even a recent thing in the U.S. I mean, even a decade-plus years ago, you pull up like a traditional multi-factor-based stock that screens well and then you look at the holders and it’s like 12 different quant funds. You know, it’s everyone, you know, all the names, D.E. Shaw, on and on and on all the way down. And so when you think about the edge, like you said, it’s like everyone has the same PhDs and the same databases. And so it reminds me of the old monger talking about where to go fishing, in the U.S. is a place where there’s lots of fishermen and many other places around the world, there’s a lot less competition, but it’s also in many ways harder too, like you got to make the effort and clean the data that you’re not just presented with a clear crisp dataset from FactSet.
There’s a laundry list of sort of consistent concerns that people have when it comes to, especially emerging markets, foreign markets in general from the U.S. And we hear the same ones over and over again. I understand U.S. stocks, currencies, headache, but there’s even some that are specific to China. Maybe walk through a couple of the ones you hear the most of. I imagine questions about state-owned enterprises have to be in the top three. Let’s hear you either agree with or dispel some of the biggest reasons not to invest in China and how to think about those.
Jason: State-owned enterprises, you know, it’s not just China. A lot of EM are dominated by state-owned enterprises and I think a lot of people take a blunt instrument to that concern and just say, “Hey, let’s just exile all the state-owned enterprises.” Now, in China, if you exile all the state-owned enterprises, you are not going to have a lot left over, certainly at least not in the large-cap spectrum of basically all the Hong Kong-listed stocks, which are the bulk of what’s in MSCI EM, right? Like you would have like no China leftover in your MSCI EM if you want to take out the state-owned enterprise. So you want to look at it more carefully, right? You really do want to think about, “Well, are state-owned enterprises bad, right?” The theory seems to suggest, okay, well, if someone’s running the company with a secondary or maybe even a primary concern that’s not related to profit maximization, that can’t be good news. That’s just poor governance.
We looked at the different state-owned enterprises and see, what does the data tell us? And what we found was you kind of have two extremes, right? On the one extreme, you have these regional-affiliated controlled state-owned enterprises, basically where the chairman, the CEO are sort of a local political boss and our suspicions are right. They care a lot about local employment, local GDP. They’re often the biggest employers, biggest taxpayers in the region. And there’s almost like no separation between the government and the state-owned enterprise. And there’s just a lot of sort of messiness and some maybe political graph that the firm gets involved and become a conduit or sort of shady dealings. Also there, the performance of those regional state-owned enterprises, they are 5%, 6% behind the rest of the market.
But when you look at the centrally-connected state-owned enterprise, meaning the chairman, the CEO came direct from Beijing, the performance’s usually 2%, 3% better than the rest of the market. And when you think about it, well, that sort of makes sense, right? It’s like Beijing’s finally fed up with a particularly state-owned enterprise, sends in the A-Team. These other people are coming in to make things happen, right? To get rid of whatever it is that is not working. And everyone pays attention, right? You know, everyone’s working super hard. It’s national attention being put on this company. So you actually do see very strong performance, very strong recovery, and oftentimes, it’s also a signal that some kind of major policy tailwind is going to come the way of this company. When you look more carefully, there are state-owned enterprises and there are state-owned enterprises. So that’s kind of useful to know. And so you don’t really want to throw out a baby with bathwater in this case.
Meb: I actually think the same way on that. How do you guys put together the portfolio in the ETF? Number of names, sector, composition. I looked at it and it seemed you had a decent financials exposure, decent tech exposure. How often is it rebalancing? What’s the approach?
Jason: We start with a very large universe. As I mentioned, now there are 3,800 liquidly traded names. We don’t start that aggressive. We start with kind of the 800 that are really good liquidity, large enough capitalization, you’re not likely to move markets with these stocks, and then from there we start to pair it down to ultimately about 100 stocks that we liked the most and they’re going to be broadly diversified across different industries. And obviously within industries is where we really pick firms that we truly think are high-quality, great management, they’re safe from a capital structure from a volatility perspective, and their value fairly have good growth potential. Now, of course, all of that done quantitatively rather than qualitatively, but we’re a big believer that, you know, the qualitative approach can work very well. It’s just a matter of applying data and work even better in a quant approach.
That’s how we construct the portfolio. And now we obviously bring into the construction process, the latest technology, the latest sort of empirical methodologies available. So a lot of big data-type econometrics, machine learning, robust optimization, very, very aggressive. I would say sort of down-waiting to fight against in sample, data mining, that sort of thing, what you would expect a very, very good academic quant to do. You know, we do all of that. And these quantitative techniques work extremely well in China. And the reason it works extremely well in China is because it’s just a more inefficient market where those techniques haven’t been applied and haven’t been employed. And so we’re being able to take advantage of going into essentially a greenfield market where quant approach is new and therefore it’s not crowded there.
Meb: You referenced this in the beginning and coming back full circle to kind of the growth value. And as we look at sort of a top-down macro lens at what’s going on in China, like where does it stand? Is the market in general? Is it cheap? Is it expensive? Are there pockets that are bubbly or not? Are there areas that are generational opportunities? How are you seeing the lay of the land in general? And feel free to, if you want to talk about any specific names, you’re more than welcome to as well.
Jason: The median stock in China is not expensive. Certainly, if you look at the price to trailing earnings or price to smooth past, you know, five years of earnings, you know, China is kind of medium when it comes to valuation multiple versus U.S. U.S. is about two, maybe, you know, three standard deviations away in terms of relatively more expensive. So China is certainly not expensive, but you’re right. The cross-section, the dispersion is enormous, right? The banks in China are as cheap as anything can be. And then the technology firms are even more expensive than the technology firms we see in the U.S. right? Take for example, in the U.S. we have Tesla, which has gone up 6X in the last 12 months. There is a China Tesla, Neo. Now, that firm happens to be listed on the New York stock exchange. It’s because it couldn’t qualify for listing in China, right? It’s just a company that’s near-bankrupt and makes no money. It loses $44 a share. For every car it sells, they lose like $100,000, right? This is China’s answer to Tesla. Neo has gone up 60 times in the last 12 months, right? It’s gone from a penny stock near bankrupt to a $60 billion market cap company near bankruptcy. And then that’s just how stretched valuation, multiple can be in a cross-section.
And so when we’re looking at it early, you know, that’s not the kind of bubble we want to participate in because you get into that, it could run. And it could run from 60 billion to become 120 billion in market cap, but it could also go the other direction. And then if it goes the other direction, you probably can’t come back to that one. So things that are probably more sensible, if you want to participate in China growth in a more quality-oriented way, look at banks. Right now, most people are going to be shocked by that recommendation because people will think of Chinese banks are horrible, right? So much bad debt on their books. I mean, maybe even a lot of hidden bad debt that hasn’t even be recognized. And, again, that is a bit of a, I would say, a misconception of how banks actually operate in China, right? We think about all the banks are state-owned enterprises and they must make lots of bad loans to other state-owned enterprises that they’ll never see that money back. When, in fact, I’ll tell you an anecdote, start of last year, right? This was around COVID time. One top bank executive in China was arrested and indicted and you can go, “Oh, you know, it must be for fraud, right? Making a huge loan to his cousin.” No, not at all. He was indicted because he didn’t make enough loans. He was not supporting the real economy when the real economy was suffering, right? He was being an evil Wall Street banker, you know, not making enough loans.
And so after that, all the banks got the message and said, “Well, we got the look, sympathetic good bankers.” They didn’t go out and make lots of bad loans. Maybe a few regional ones did, all the banks simply reclassified their perfectly good loans as bad loans and started taking massive hits against their own learnings and tell the regulator, “Doing what we can. Look at our books. You know, don’t harass us anymore.” And as a result, you look at say, China Merchant, one of the best-run banks in China. And you’ll realize they got a lot of loans that’s classified as bad loans that are paying interest, right? Like, that’s not how you classify a bad loan. And then building up a massive reserve for bad loans that aren’t even bad. All they’re doing is, again, complying with perhaps a little too paternalistic interventionist policy policymakers while being very good stewards of the business. And so if you can look past the numbers and understanding the true story and understanding what’s really happening and why, in this case, you’ll find that many banks are sort of phenomenal quality value plays.
Meb: Most of the conversations you’re having advisors, investors in the U.S. I imagine the foreign story, in general, is similar to the ones I have, which is stories old as time, which is people traditionally are pretty under-allocated outside the U.S. with the whole home country bias, which you see everywhere. I imagine that’s particularly prominent towards China, and you can correct me if I’m wrong there or not. How are advisors thinking about their allocations and maybe comment on where we stand too in the whole benchmark inclusion story? Is that a story that’s over, that’s still going on? What’s happening?
Jason: When we talk to advisors, often we find advisors who would say, “Well, you know, I already have EM in my EMF China. And, in fact, I don’t even like my EM, right? I’m going to cut my EM and double down on a U.S.” You just hear a lot advisors who say that it’s. Like, “EM’s been a bad diversifier.” And by that, they mean, well, EMs underperforms, right? And, of course, when you diversify, right? There’s always going to be one thing that is better than the other, right? That’s the point of diversification. But most advisors who have been experiencing EM underperformance feels like that’s been a bad diversifier. We hear a lot of that. And the data actually, it’s kind of surprising. If you take China out of EM, the corporate earnings growth, right? EPS growth for EMs in China has been 2.5% nominal, right? If you take out inflation in EM, it’s actually negative.
EM Corporations have actually done very, very poorly when you exile China. And there may be structural reasons why EM could structurally underperform. EM has only done okay-ish because China is in it. If you look at China independently, last 15 years, China’s growing at 14% year over year earnings growth, which is actually 3 times as high as U.S. corporations. For the last 15 years, U.S. corporations only grew at a shade over 5% year over year nominally. So first thing is to just tell people, “Look, if you don’t like EM, you know, China is not what’s driving that problem. Like China’s actually unique and it’s like the savior for the EM portfolio.” And then, of course, next question is, “Okay, I got EM. And 40% of EM’s already China. Would I really want to do more China?” If you look at your MSCI EM, within it, most of the China exposure is actually the Hong Kong shares, the H and the ADRs.
And so if you look at those firms versus the A, which has got a tiny bit only in the MSCI index, the offshore actually grew at about half the speed. So the earnings growth is only half the earnings growth of the China A. So the MSCI sort of included the wrong part of China. So it’s a lot of state-owned enterprise. It’s a lot of firms that have low-quality that list in the U.S. who have poor growth. So if you look at your EM exposure, the China in there isn’t what you want, right? They’re not the one that’s giving you high growth and also they’re not the ones that are onshore, which have a lot more alpha potential. So that’s what I sort of highlight to advisors when they think about EM, China, and EM, do they really want more China?
Now, of course, this will change gradually as more of the interesting China, which is the China A exposure are included more into the MSCI indices. So, Meb, as you mentioned, MSCI has promised to add more of the proper onshore China over time because access is easier and they do realize that there’s great transparency data available for onshore Asia, so there’s really no reason to exclude them. Today China A is 0.4% of the ACWI index, barely 4% of the MSCI EM index. And those are all likely to increase by 5X over time. So we can expect a lot more passive flows or benchmark aware flows to go into China A over the next few years. And, again, for advisors, some of them, that does give them comfort, to know that they’re not going to be alone going into China A. That it’s going to be a huge part of the index and there’s going to be a lot of flow coming after them if they move earlier today. And I think that’s been a positive reassuring change on the horizon for a lot of the advisors. And, of course, obviously, we are under a new administration. The U.S.-China tension is likely to at least be different, right? It’ll be reduced. It will be different. And I think that’s given some advisors greater comfort that the headline risk, let’s call it, or the broader discomfort driven by the U.S.-China tension would spill over to sort of a negative client reaction. So these are the things that we’ve heard from advisors.
Meb: Talking to investors in emerging markets in general, but really foreign, so much of the dialogue and narrative gets caught up with what’s going on with the government, what’s going on with public policy, which often can be totally distanced from what’s going on with the companies. And the name in the companies can go on to get distance from what’s going on with the stocks too. Presumably, you said you had a number of funds that have been managing in China. You guys got planned on launching some new funds as well. Is this going to be a one-trick pony? Are you going to do a whole lineup of funds?
Jason: Absolutely a whole lineup. We’re going to bring over from Asia many of our strategies that are appropriate for U.S. investors. So we brought over the first one. You’ll think of the first one as the flagship core offering, right? If you want to have one strategy to kind of cover your China gap in your portfolio, this large-cap high-quality portfolio, I think is the one that is right. It’s safe, it’s going to let you participate in the growth. It’s in all the interesting, the right names that are going to experience growth over the next 10, 20 years. But certainly where there’s just a lot more alpha or there are a lot more interesting price dynamics are going to be in the small caps. So we have a very successful small-cap growth product in China that I think was the best-performing China ETF in the world last year. In terms of return, it produced like, you know, something like 98.5% return. We’re going to bring that over for people who really want, you know, very concentrated dosage of the small and the growth factor in their portfolio.
So, yes, the whole lineup, obviously we want to bring over fixed income capabilities, where, for taking on China sovereign credit, you can earn 3% additional yield, right? If you think about it, you know, China probably has a better sovereign credit than the U.S. in a sense that they’re printing less money than we are and also U.S. owes China $4 trillion. So it’s unlikely that China will default on anyone before the U.S. defaults on China. So that’s certainly, I think interesting for advisors who are looking for a fixed income alternative that isn’t yielding zero.
Meb: It’d be interesting to see on that. I think the equity side is despite what we’ve talked about on some of the commonly held misconceptions as well as hang ups people have, fixed income, particularly with foreign bonds, I think a lot of people get stuck in their head when they think of foreign bonds, they think of negative-yielding. They just assume like, “Well, I can get 1%, 2% here. Elsewhere sounds even worse.” But that’s not always the case. Plenty of markets are higher-yielding and of varying credit quality versus the U.S. But I see probably is relative to the global market portfolio benchmark. That’s got to be the biggest underweight in my mind, is U.S. investors investing in any foreign bonds at all. Most investors I talk to don’t invest in any foreign bond markets, sovereign or credit.
Jason: I think there is probably a psychological bias. We think of, “Well, the bond portfolio is a safety portfolio.” So even if it doesn’t provide much yield, it provides safety. In extreme events, flight to quality, it’s going to go to dollars. It’s going to go to U.S. treasury. And that’s true in the short run and obviously when extreme events happen, that’s certainly been true. But I think the joke that calls U.S. bonds as a not risk-free return but return-free risk, that’s increasingly not a joke, but that’s increasing the reality, right? You hold something that’s yielding less, and inflation, right? You’re getting a lot of risk. More inflation, the more you lose. Or if the government wants to stop inflation, raise rate, you lose even more. There’s not a winning outcome there in the long run. So I think it is an under-examined area in most client portfolios. Why do you have in your 60, 40 split 40% in mostly so U.S. high-quality government debt? That really doesn’t make sense.
Meb: That’s a conversation we often talk about. We say the world’s largest asset class, foreign ex U.S. bonds, and almost no one we talk to has ever allocated. I think a lot of it gets caught up in fears of currency moves. How do you guys think about currencies in general? I assume the funds are unhedged or do you hedge some of them, or do you have variants that you consider? How do you guys think about it?
Jason: We’re definitely unhedged. Part of it is hedging from renminbi over to the dollar, right off the bat you lose 3%, right? And there’s just no reason to give up 3% in this environment where it’s so hard to earn yield. And if you look at emerging Asian currencies, as that economy is emerging, right? As its per capita GDP is catching up with the rest of the world, what you see has always been strengthening currency. So we kind of got data and history on our side, why being unhedged on your renminbi is a smart move. And you add on top of that, really the ambition of China to rise up as a global superpower, if not a solid number two, I certainly would aspire to be maybe even on par with the U.S. So, you know, that kind of ambition often means you’re going to get the renminbi into a settlement currency. It’s already part of the SDR for IMF. So that currency could actually at some point reach almost U.S. dollar-like status. And that’s going to mean a lot more appreciation for the currency. Not guarantee, but certainly, with that political aspiration and that economic aspiration, the likelihood is a strengthening currency versus a weakening currency.
Meb: What’s the timeframe for these new funds coming out? It would be this year, next year? Some, both?
Jason: Well, we’re certainly hoping to bring something out probably every six months. And it gives us a chance to get the existing ETF to a certain size and on a platform before we work on the next one. But we certainly like to get them out to investors as soon as we can.
Meb: Excellent. We’re looking forward to all those. As we kind of wrap a bow on the China discussion, anything else we didn’t cover that you think is either underappreciated, over appreciated? Have any insights on where Jack Ma has been all this time?
Jason: I think it’s definitely fun to talk about Jack Ma because that’s probably the one thing, all the conspiracy theorists really wanted. It’s easy to spin that into like, you know, there is just no property, right? If you’re too successful, you’re too wealthy, the government goes after you. And this is what happened to the Ant Financial IPO. And that’s a spectacular story, catches eyeballs, but it’s just not true? If you look at the government allegation of why the IPO can’t move forward, it’s because the government realized that Ant Financial as a technology company trying to disrupt. They certainly would like to encourage that for innovation’s sake. What they also realized is Ant Financial was getting into insurance, micro-lending, credit cards, bank lending, taking in deposits, selling mutual funds. It was in every single regulated business there is in China. And these would be regulated businesses everywhere else in the world and they have, I think, one-thousandths of the required capital for all the regulated activities they’re undertaking. And they knew if the regulators take a closer look, that Ant Financial actually would fail as a company, and then to protect investors from brushing into that hot IPO and they have to call it off and really look at all the businesses that Ant Financial has gotten into, that they really don’t have the license to nor the capital adequacy to support.
Of course, so secretly Jack Ma was placed under house arrest. And, you know, this isn’t the where they go waterboard and make him confess to crimes he has not committed. You know, this is where they basically say, “Look, you know, Ant Financial or Alibaba is not the only giant tech companies in China that have gone into banking, wealth management.” Many other tech companies have. And they simply need to understand, well, what is the business model? What is the risk? How do you regulate? Because you as an insider can best help us draft regulation and make this right. It’s really not as exciting as people thought it was, right? Sure, you know, Jack Ma’s an outspoken person and he tends to want to be the smartest person in China and then that job, unfortunately, is not available. But that’s not the primary reason for why the Ant Financial IPO was stopped.
The one thing that I think is on people’s mind is we look at the U.S.-China dynamic and we tend to want to think that Cold War is coming. We tend to want to map that to what we recollected as the U.S.-Russia Cold War. And then that’s because China’s a communist country and that sort of maps well over to Soviet Union of the yesteryear. But that’s probably not the right mental imagery. The right one is likely the U.S.-Japan relationship when Japan was rising as the head of the Asian tigers. That’s what China is doing today, right? Its per capita GDP is rising rapidly. It’s gone from very low-value add manufacturing to very high value add manufacturing. In fact, having its own brand. It’s becoming wealthy and one of the larger consumer marketplace where it’s important for U.S. manufacturers and U.S. brands.
So the relationship between U.S. and China is much more like U.S. and Japan. And so it’s not one that’s likely to be determined and dominated by political and geopolitical considerations, but more trades and tariffs. So if you look at it that way, it’s less scary. And it’s a kind of co-opetition that we’ve seen before. Competing because both want to sell and want both markets. They want to compete and win in terms of trade, but they also lean on each other because you have to have another side to trade. You can’t just trade with yourself. And so that kind of co-opetition I think is long-term healthy for both sides. You know, both markets and market participants are just going to create more wealth and more prosperity as long as things don’t sour and we go into a pissing match and a trade war.
And so I hope investors see it and understand it that way because that would certainly make investing in China less scary. And also I think because of this co-opetition, the negative correlation between the two markets are likely to persist because in the short as they compete, there’s a little bit of zero-sum. In the long run, the pay pie is just getting bigger. So you actually have two markets, both growing but different regulatory environments but yet both growing and while they short-term compete, they’re long-term collaborating and building a bigger pie. And then I think if you have both in your portfolio, you’re going to win on the return side and you’re going to win on the risk reduction side. Now, you don’t have to bet on a winner, right? You don’t have to bet, “Oh, is China going to be the winner? Is U.S. going to be a winner?” I think they’ll both be winners.
Meb: It’d be fun to watch certainly. As someone who’s had a number of different roles as an analyst, portfolio manager, founder, professor, last few years have been entertaining as always, a little crazy with markets. We had the pandemic, we had GameStop. We had crazy out-performance spreads on value and other things. Any other general thoughts on markets in the first quarter of 2021 or things that got you scratching your head or excited about?
Jason: Well, the thing that’s really got me scratching my head is I’ve always expected China to gradually converse toward the U.S, right? The markets will be more institutional, more rational. But the convergence seems to temporarily go in the other direction, right? I mean, U.S. has gone from 3% in retail trading to I think almost 30% retail trading and you have what dominates financial news, really GameStop, and the Meme stock. And that’s been the surprising thing. And as a researcher, it’s kind of fun to watch. Efficient market’s kind of boring to study. It’s much more exciting today to see what’s going on.
Meb: There’s a handful of rhymes with various periods. As a student of history, that’s always seductive to look back at the times and say, “Well, this looks just like this,” whatever it may be. And more often than not, there’s parts of it, certainly, that look familiar over various periods. You know, you can certainly see some late ’90s similarities in some of the stuff going on, the retail interest, some of the high-flying names, but other things look different as well. Are you still teaching anymore or is that on hold since pandemic and why you’ve been running around the world, starting a company?
Jason: It’s been hard to teach in person, and I try to teach one class online. My God, it’s like three hours of talking to yourself. It’s not a good experience. I’m sure it’s not a good experience for the students. It’s certainly not a good experience for the teacher. You don’t get any feedback on. It’s like, “Is it going well? Are people are getting it?” You don’t see any body language. And, of course, you got 60 students, right? So you can’t have everyone’s camera be on. And then literally it’s like just you talking to an iPad. I hope we can go back to an actual classroom very soon.
Meb: Data will have holograms here soon. I can’t be too far away, right? Where VR, VR classrooms, who knows? Jason, people want to find out more about Rayliant, the new ETF, R-A-Y-C is the ticker, where do they go?
Jason: Come to our website. So come to www.rayliant.com and there’ll be all sorts of links that take you to the landing page with a fund that gives you more information about our research, more information about the company, the people, hopefully… Also, follow us on Twitter and LinkedIn. I don’t know what Twitter and LinkedIn actually does for business. I am starting to be addicted to seeing people like my articles. So I know it makes no sense, but it’s very addicting to see people liking your articles.
Meb: Well, you got a lot of great ones and we’ll link to them in the show notes. And certainly any you put out in the future, keep us on the distribution list. And when you do a Chinese investor tour, let me know. I’ll come join. Having never been, it’d be fun to tag along and…
Jason: Come with me. In China, it’s GameStop every day, I tell you.
Meb: That’s warned me out this year already. We’re only two months into 2021. And I thought it was going to be nice, peaceful post-2020. And I think things are just getting crazier by the day. So, who knows? Jason, thanks so much for joining us today.
Jason: Thanks, Meb.
Meb: Podcast listeners, we’ll post show notes to today’s conversation at mebfaber.com/podcast. If you love the show, if you hate it, shoot us feedback firstname.lastname@example.org. We love to read the reviews. Please review us on iTunes and subscribe the show anywhere good podcasts are found. Thanks for listening, friends, and good investing.