Building a Hedge Fund in Australia with Exposure to the Chinese Economy

In 2010, China was Australia’s main trading partner for goods and services accounting for 19. 1% of total trades . This Sinodependance enables on average an Australian balanced superfund to have an exposure of 11% of its net assets to the Chinese economy mostly due to the impact of mining giants such as BHP and Rio Tinto (more than 10% of the All Ordinaries Index). The first part of this assignment tries to identify companies and selection rules in order to set up a fund (named Super China Exposure) that invests in Australian listed companies with exposure to the Chinese economy.

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The second part gives details about weights of selected companies, then a pure-play strategy is established and finally the performance of this fund is discussed. portfolio selection Investment objective Exposure to the Chinese economy Super China Exposure is designed to invest in companies that have an exposure to the Chinese economy with an active management strategy. The Fund is limited to Australian companies which reduces two major risks: political and exchange risks (Super China Exposure currency is AUD since it is designed for the Australian market).

In order to minimise political risk and attract concerned investors about China’s political situation Super China Exposure invests in companies that do not have strategic subsidiaries in China (eg: BHP Billiton business in China is reduced to marketing and Mineral exploration ). According to this constraint, the fund aims at: minimizing the risk/return ratio of stocks with positive alphas beat its benchmark (ASX small cap- refer to Portfolio evaluation section) Security number and asset mix

In order to limit transaction costs and based on Meir Statman’s research, Super China Exposure fund invests in a moderate number of securities with exposure to the Chinese economy so that the risk/return ratio is minimized. This number is set at 15. Based on China’s 12th five-year plan release in March 2011 and analyst’s growth expectations Super China Exposure fund investment manager believes that Chinese growth will remain strong over the next years and share prices of Australian companies with exposure to the Chinese economy will continue to expand.

To benefit from this expansion Super China Exposure fund invests 100% of its assets in equity securities. Sector selection A pure-play strategy (discussed in part 3) allows hedging against markets movements so diversification does not play a significant role in Super China Exposure strategy. Table 1 (please refer to appendix) summarises Australia’s exports per sector in 2010. Goods represent around 90. 75% (AUD 58,402 million) of Australia’s total exports to China (AUD 64,356 million). In 2010, more than half of Australian exports to China are composed of Iron, ores and concentrate (AUD 34,681 millions).

Companies within this industry will definitely belong to Super China Exposure fund but the fund manager also takes into account other sectors relying on the Chinese economy that would allow some diversification. China might continue to experience a high growth over the next years, all companies within sectors in Table 3 (please refer to appendix) are considered such as other crude material mining companies (ie copper) or mineral and fuel companies (ie crude petroleum). Table 2 shows the importance of education-related sector to China being the third biggest sector.

For the time horizon 2011-2015, priority is though given to companies in table 3 (primary and manufactured product companies). The release of China’s 12th 5-year plan in March 2011 estimates a 7% GDP growth that might largely involve Australian companies in the development of transportations, urbanization or construction and renovation of 36 million apartments for low-income families. Service companies might be included in the future as their proportion of exports to China increases. Security selection

As at 14 July 2011, 2321 companies were listed on the ASX and 994 belong to the Material and Energy sectors . Each of them can have a high exposure to the Chinese economy so security selection is not only based on sector analysis and includes: First : the “Size effect” In the late 80’s Fama and French found that even after adjusting for risk, small firms could deliver “abnormal returns “which became known as the size effect. In Australia Chee Seng Cheong Fin and Justin Steiner (winter 2007) study revealed a strong “size effect” on listed companies from 1991 to 2006.

Second: a Fundamental analysis As requested by its main constraint Super China exposure selected companies shall have an exposure to the Chinese economy. The assessment of the growth perspective and percentage of profit coming from China is part of the selection process. Super China exposure investment manager also bases her choice on the assessment of the companies’ management such as the debt level, cost management, return on investment. To lower the risk, she finally selects liquid assets that have a “trading history” on the ASX (ie: more than a year). Portfolio weight

Size effect 100% of portfolio weight relies on companies whose profit is coming from China with a small to medium market capitalization. Fundamental analysis The Australian market is composed of a few very big companies and many very small companies. Since Super China Exposure fund seeks to take advantage of the size effect it does not make sense to invest within companies as a percentage of their market capitalisation. As Siegel pointed out in the Wall Street Journal in 2006”prices of securities are not always the best estimates of the true underlying value of the firm”.

He suggests that “fundamental indexation is a simple way to capture these mispricing”. This strategy perfectly suits Super China Exposure Fund since: it is an alternative to market capitalisation weighting. Weights are decided based on fundamental metrics such as aggregate profit from China. it allows the fund to capture positive alphas: buy undervalued shares sell them when price increases. Market capitalization weighting tends to overweight overvalued stocks Based on this analysis, the portfolio is rebalanced on a regular basis which incurs transaction costs.

Pure Play Based on weights and stock selection, Super China exposure fund buy undervalued securities so the alpha of the fund is positive. However it invests in Australian securities and its sensitivity to the Australian market is positive. To hedge against factors other than the Chinese economy that affect Australian equities, the fund sets up a pure play strategy. Systematic risk of the portfolio can be hedged by selling future ASX SPI 200TM contracts. The number of contracts is defined as below:

C= (number if shares*value of each share)/(ASX future position*beta of the fund) Portfolio performance The performance of Super China Exposure fund can be compared to an appropriate Benchmark that will assess the fund manager’s ability to identify positive alphas within small- mid cap stocks with exposure to the Chinese economy. The ASX small ordinaries might be an appropriate benchmark since: It emphasises the size effect (Mining Giants such as BHP or Rio Tinto or other major companies are not included in the index)

Nearly 50% of companies within ASX small ordinaries belong to Material and energy sector. ? Appendix Source of charts and tables: Australian government, department of Foreign Affairs and Trade (2010), composition of Trade report. Chart 1Chart 2 Table 1 Table 2 Table 3 Australia’s trade of goods with China Table 4 Australia’s trade of services with China ? References Australian government, department of Foreign Affairs and Trade (2010), composition of Trade report, from http://www. dfat. gov. au/publications/stats-pubs/composition_trade. tml The Economist online (28 October 2010), Sinodependency [Electronic version], The Economist, from http://www. economist. com/blogs/dailychart/2010/10/dependence_china James Dunn (21 april 2010), How to tame your portfolio Dragon [Electronic version],The Australian, from http://www. theaustralian. com. au/business/wealth/how-to-tame-your-portfolio-dragon-china/story-e6frgac6-1225854673743 BHP Billiton (2011), http://www. bhpbilliton. com/home/businesses/Pages/GlobalOperationsMap. aspx Deng Shasha, (5 March 2011), Key targets of China’s 12th five-year plan, English. ews. cn, from http://news. xinhuanet. com/english2010/china/2011-03/05/c_13762230. htm Australian Stock exchange (2011), http://www. asx. com. au/asx/research/listedCompanies. do Fin, Chee Seng Cheong and Steinert, justin (Winter 20007), The size effect: Australian Evidence, JASSA, 9-11 Siegel, J. (14 june 2006), The Noisy Market Hypothesis, Wall Street Journal, p. A. 14 Siegel, M. (1 june 2011), Australia’s Mining Boom Is Pied Piper for Workers, The International Herald Tribune retrieved from http://www. nytimes. com/2011/06/01/business/global/01ozecon. html


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