The China stock market has been declining for three consecutive years, and the overall valuation already at historical low. Nevertheless, it encountered a nightmare start in January and early February 2024, during when the CSI 300 index fell by only 10% maximum thanks to the liquidity support by China sovereign funds, whereas the CSI 1000 and CSI 2000 indices fell to maximum of 29% and 37% respectively. The market has rebounded after the Spring Festival, but by the end of March, the median YTD performance of all A-shares (over 5,000 stocks) still at negative 13%.

The stock market had already been at a low level before the Spring Festival, but it experienced a disastrous crash in a short period of time due to multiple factors. The market environment is becoming increasingly complex, including stock index futures, snowballs, DMA, and quant trading, which can cause unexpected chain reactions and extreme situations. Some risk control experience from the past may not be effective any more.

We have gradually adopted a combination of active fundamental and quant approach since last year. Why do small-cap stocks appear to have high exposure in quant strategies? It is not because small-cap stocks are more elastic which may provide high beta. In fact, the high volatility of small-cap stocks enshrouds their long-term alpha. The small-cap stocks in China market are characterized as higher trading activity, lower institutional holdings, and a greater possibility of mispricing, all of which imply rich excess returns or alpha. This is also the common reason for the high exposure of small-cap stocks in China quant funds. In addition to the above reasons, we also take the factors such as investors’ behavior, structure and macroeconomic environment into consideration.

Investors’ behavior and structure in the China stock market are exceptional. At present, there are over 3,000 stocks with market cap less than RMB 5 billion. These stocks are not only actively traded, but also influenced by many themes and topics, which produce strong rotation effects. From our observations, the returns generated by these rotation effects have been around for a long time in small-cap stocks, and still exist. This is related to investors’ behavior and structure in the Chinese market. There are many small and medium-sized individual investors in China market who trade small-cap stocks, providing good liquidity for them. According to the data released by the exchange, from 2017 to 2022, individual investors held average of 50-55% in stocks with market cap below RMB 3 billion, while the proportion was 23-31% for stocks with market cap above RMB 10 billion. This is completely different from the US and Hong Kong markets. Meanwhile, the Chinese investors are keen on stocks with hot topics or themes, which sustains rotation effects in small-cap stocks.

Last year, the overall China economic recovery didn’t meet the expectation, and the market as a whole lack of key sector momentum. Under these circumstances, stock selection became more difficult. Small-cap index was relatively strong last year, and this was not due to a significant increase in valuation, but mainly from the returns of rotation effects.

There is a certain degree of crowdedness in small-cap stocks, but it has not yet reached an extreme level. From the perspective of the proportion of stock holdings by various types of investors in the China market, the larger the market cap of a stock, the higher the proportion held by institutional investors, therefore higher the institutional crowdedness. According to data released by the exchange last year, by the end of 2022, the proportion of shares held by institutional investors with market cap above RMB 10 billion was 24.7% on average, while the proportion was only 10.2% for stocks with market cap below RMB 3 billion. We estimate that by the end of 2023, the proportion of shares held by institutional investors with market cap below RMB 3 billion will not exceed 15%, still significantly lower than large-cap stocks. After the significant decline of small-cap stocks in the first quarter of this year, the current institutional crowdedness is expected to decrease.

Some reflections on the start of this year. Performance pressure has given us no time to wait longer for better opportunities. Over the past few years, the overall market has been declining, and our funds have also been declining. As a fund manager, there is a lot of pressure to deliver performance, and we have not been patient enough to wait for better risk-return opportunities. We may have underestimated the potential risks when the market is already cheap. After three years of decline, both large-cap and small-cap stocks are at historical low level. We diversified holdings among broader sectors and smaller single stock exposures to reduce individual and sector risks, but these measures were not able to avoid systemic risks.

We will continue to apply quandamental approach and maintain current investment focus, while research and track other investment directions as alternatives. Including high growth stocks from sectors at upswing trend, and stocks with high dividend yield, that are perform well this year. The state-owned enterprise reform is also worth tracking. However, we need to be cautious in such a bearish market which does not attract capital inflow even possible outflow, we should avoid chasing directions that already moved high, meanwhile keep option open for adjustment.

We will modify investment direction and strategy according to changes in the market. Over the past five years, from investing in large blue-chip stocks to the addition of growth stocks, then to the quandamental approach, we have made our investment decisions based on the changing market conditions.

Although this year started unfavorably, it doesn’t mean no opportunities over the later months. With the replacement of the Chairman of the China Securities Regulatory Commission, the tightening of IPOs and major shareholder sell-restrictions, and the influx of bottom-buying investors, the market has had a reasonable recovery after the Spring Festival in February. As capitals are searching for investment directions, the attractiveness of China equity is gradually increasing after three years of bearish market. In this difficult time, let's respond with calm and vigilance, look forward to the lights of dawn.