Testing Equity Factors in Chinese Stock Market

China’s economy has been growing at an astonishing speed in the last 30 some years, intriguing investors to get a share of return from this upward market by employing the quantitative equity factors proved to be working effectively in the U.S. stock market.

Before jumping into the water unfathomed, it’s always wise to conduct your due diligence work beforehand. An article — Anomalies in Chinese A-Shares – authored by Jason Hsu et al. early last year gave a thorough research on this topic (the original copy is available on SSRN ).

The overall conclusion Jason Hsu and his coauthors draw is twofold:  “first, naïve application of U.S. strategies to Chinese stocks may lead to undesirable results, as not all strategies familiar to U.S. investors outperform in A-shares and—even worse—some actually work in the opposite direction; second, a thoughtful approach to factor design and portfolio construction based on knowledge specific to A-shares and the related financial landscape has the potential to produce superior outcomes for investors. ”

The returns and accounting variables for all A-shares stocks data they used are sourced from the China Stock Market and Accounting Research (CSMAR) database, and as a comparison the U.S. data from Kenneth French’s website.

The factors tested and investigated per prior literature are Values, Size, Momentum/Reversal, Low Volatility and Accruals/NOA:

  1. Value Over the full sample, A-shares exhibit a strong value effect. Value-weighted returns associated with dividend yield as yields a 5.7% return per year, whereas sales-to-price value metric based strategy returns 11.7% per year. However, the return turns to insignificant since 2008, possibly because of the reform of accounting rules in China to be in conformation to IFRS.
  2.  Size They found a very strong size effect in A-shares. An investor buying the smallest stocks and shorting the largest firms produced value-weighted returns of 14.6% per year over the two decades covered by our analysis, results which are significant at the 5% level. There are several explanations such as special phenomena in Chinese stock market that small listed firms offer substantial “shell value” as candidates for reverse mergers; another reason indicates retail investors only pursue large cap state-owned stocks, driving the small stocks price too low.
  3. Momentum/Reversal They found the traditional intermediate-horizon momentum strategy fails for Chinese stocks, producing insignificant negative returns in the full sample period. At the same time, a factor trading on short-term reversal produces an equal-weighted return of 8.3% per year in the full sample, significant at the 5% level. A research paper claims that Asian investors are faster to adapt to prior gains and losses than their American counterparts, which accounts for this reversal effectiveness in A-Share market.
  4. Low Volatility  They found that over the full sample period, higher risk—whether systematic or firm-specific—predicts lower future returns for A-shares.
  5. Accruals/NOA  The predictability of both – high accruals to lower return and high NOA to higher performance – is marginally significant. Both U.S firms and Chinses firms manage their accounting books reflected in the kinks at around 0% in following two graphs, with the U.S.’ plot much less pronounced. Capture

So what causes the A-Share market to display this idiosyncratic characteristic? Here are a couple of considerations: China’s 2006 accounting reforms, State-owned stocks (over 50% of A-shares market cap was classified as deriving from SOEs as of the end of 2016), and a large proportion of retail investors in the whole investor pool …




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