Chapter 2: Overview of China A-Shares

This is the second installment in a series of articles on Investing in China A-Shares. The first, “Allocating to China A-Shares,” can be found here.

Quick and important disclaimer: The analysis and views expressed in this discussion are my own and do not necessarily represent the views of my employer or any organization I am affiliated with. Nothing in this article constitutes investment advice or a recommendation to buy or sell any security.

If you are new to China A-shares, getting a good overview of the markets and various microstructure issues is important. If you are an experienced practitioner, regulations change sufficiently frequently and there are enough implicit rules that it is worth a refresher. For example, while short selling was not explicitly banned in the past decade, few investors were allowed to lend stock since the 2015 China A-shares crash. In mid-2020, mutual funds, pension funds, and insurance companies among others were allowed to lend shares, causing a boom in short selling, though in absolute terms, the volume is still much lower than other markets.

In this chapter, I will provide an overview of the Chinese stock market, focusing on its unique features and recent changes. Of course, if someone is trying to sell you China equity products, they will often tell you how different China is to convince you that the normal tools of analysis do not work and that you need to pay them to manage your money. They will also probably tell you that you cannot trust any of the released numbers and you need an expert to analyze them. Practically, it may make sense to pay someone to manage your China A-shares portfolio, but the differences between China and the rest of the world are often exaggerated for the sake of a sales pitch. This chapter is meant to give a tempered and precise analysis of the China A-shares market and its differences from other markets.

The China A-Share Exchanges

In the first chapter, we discussed the differences between A-shares, China ADRs, and mainland Chinese stocks listed in Hong Kong (H-shares, Red Chips, and P Chips). Here, we will focus on A-shares. Note that B-shares, the once popular way used by overseas investors to access the Shanghai and Shenzhen Stock Exchanges, are no longer the preferred channel. Therefore, we will exclude B-shares in the discussion below.

The Shanghai main board and Shenzhen main board are 30 years old. As of the end of February 2021, Shanghai’s main board has the greatest large capitalization tilt with 1,585 stocks and 49.4 trillion RMB total market capitalization. Shenzhen’s main board has 459 stocks and 10 trillion RMB total market cap. Shanghai’s main board stocks tend to have a lower free float percentage at 36% than Shenzhen’s main board at 53%. Shenzhen’s Small and Medium Enterprises (SME) Board has 1,000 stocks comprising 14.2 trillion RMB in total market capitalization.

About 39% of the Shanghai Main Board’s stocks are state-owned enterprises (SOEs) while 54% of the Shenzhen Main Board’s stocks are SOEs. Only about 15% of the SME Board are SOEs, in line with the fact that SOEs tend to be larger cap. Note that the SME Board and Shenzhen Main Board are merging soon. The merger was approved in February 2021, so depending on when you are reading this, those two boards might be one.

The tech heavy ChiNext, also known as the Growth Enterprise Market (GEM), was founded in 2009 as part of the Shenzhen Stock Exchange. It has been remarkably successful with 905 stocks listed making up 10.5 trillion RMB of total market capitalization. Partly in response to the success of ChiNext, the Shanghai Stock Exchange launched the Science and Technology Innovation Board, creatively abbreviated to STAR. The STAR market has 223 stocks totaling 3.9 trillion RMB total market capitalization. As one might expect, ChiNext and STAR have far fewer SOEs. A mere 6% of ChiNext stocks are SOEs while slightly over 1% of STAR’s stocks are SOEs.

Unique Features in China A-Shares

The first thing to realize is that all markets have unique features that likely present opportunities to better analyze stocks and earn excess returns, but China’s stock market is also enormous, so the benefits of learning the unique features of China are large. Moreover, because China requires firms to disclose boatloads of information, there are many signals that can be extracted from China data that are not feasible with data from other countries.

Here, we will discuss distinct features regarding microstructure and regulations and leave differences in market behavior to later chapters. . These features include (1) price limits; (2) special treatment (ST / *ST) status; (3) the constantly changing IPO rules; (4) short selling and margin trading; (5) round lots; and (6) foreign ownership limits. Two other features will be discussed in different chapters, because they require lengthy explanation: state-owned enterprises (SOEs), which make up approximately a third of China A-shares float-adjusted market capitalization, and regulatory releases including profit notices and regulatory letters.

(1) Price Limits

Since 1996, most China A-shares have a 10% daily price limit. They can go up or down 10% in a day. Once a stock goes up 10%, you cannot transact at a higher price. However, you can continue transacting at the limit price or below until market close. The same holds when a stock falls by 10%. As of late 2020, stocks on the ChiNext Board and STAR Market have a 20% price limit.

There are exceptions to price limit rule. On the IPO day, stocks have a +44% upper price limit and no lower limit. In the STAR market, stocks have no price limit during the first five days of trading. There are no price limits for stocks on the first trading day of a secondary equity offering and relisting after suspension or delisting. As in the United States, post-IPO periods are often extremely volatile. In addition, stocks under the “special treatment” (ST or *ST) status are subject to a 5% price limit. We will discuss ST and *ST stocks in the next section.

As you might guess, more volatile markets coincide with more price limit hits. Take the market response during the COVID-19 pandemic for example. When the Chinese stock market reopened on February 3rd, 2020, after an extended Lunar New Year holiday, the Shanghai Composite index fell by 9.23%, and the trading of 3,212 stocks halted, representing 85% of all A-shares.

One implication of the price limit is that the market impact of an event will take much longer to dissipate. Consider the case of Baoding Lucky Innovative Materials (ticker: 300446), which went public on May 4th, 2015, in the headiest days of the 2015 bubble and when even GEM stocks had a 10% price limit. It had 23 consecutive trading days of hitting its +10% upper limit. Then, it had numerous days over the subsequent weeks where it hit its -10% lower limit. This is an extreme case, but it illustrates the effect that price limits have on the timeliness of information incorporation. 

A circuit breaker, another mechanism often used to stem panic selling, was short-lived in China. The collapse in summer 2015 resulted in regulatory authorities attempting to control the slide by introducing such a mechanism. On January 1st, 2016, the Shanghai Stock Exchange (SSE), Shenzhen Stock Exchange (SZSE), and China Financial Futures Exchange (CFFEX) jointly initiated a two-way circuit breaker where trading of stocks and stock-related products would be halted for 15 minutes, if the benchmark CSI 300 index rises or falls by 5%. If after resumption, the CSI 300 index rises or falls by 7% or more, trading will close immediately for the day. On January 4th, 2016, the index declined dramatically in the morning session, leading to a 15-minute halt at 1:13pm followed by an early market close at 1:34pm. Three days later, on January 7th, 2016, the index dropped more than 7% in the first 27 minutes of trading, triggering the circuit breaker again. The three exchanges removed the circuit breakers on January 8th, 2016, stating that the circuit breakers had failed to achieve the goal of stabilizing the market.

(2) Special Treatment

As discussed in the prior section, stocks under the “special treatment” (ST or *ST) status are subject to a 5% price limit. A stock becomes an ST stock by losing money two years in a row, having a negative audited net worth, or having an adverse audit opinion. A stock receives a *ST status if the firm loses money 3 years in a row or if the stock’s financial position otherwise worsens. Finally, if it loses money 4 years in a year, it is delisted. Companies naturally have a strong incentive not to lose money. As we will see in a later chapter, companies in China manage earnings through a mix of accruals, timing of extraordinary items, and real earnings management.

In January 2021, the exchanges strengthened the rules for delisting. If a firm engages in fraudulent activity for two years in a row, it will be delisted. If the fraud exceeds 50% of its operating income or 500 million RMB, the firm will be delisted.

There was a considerable decline in the number of ST and *ST stocks between 2008 and 2014 when it leveled off at about 2.5%. However, after years of remaining at this level, it rose markedly in 2019 and 2020 due to a mix of a tougher regulatory environment and COVID-19 putting a downward pressure on profits.

A natural question is whether it is more profitable to invest in ST and *ST stocks. The answer is that while ST and *ST stocks are far more volatile, ST or *ST stocks do not earn excess returns over non-ST stocks. A capitalization-weighted portfolio of ST and *ST stocks had a 33% volatility from January 2000 to February 2021 and slightly underperformed a portfolio of non-ST stocks, which had a volatility of 28%. As one might guess, the ST and *ST stocks also tend to be smaller cap, so they perform well during periods of small cap outperformance and perform poorly during periods of small cap underperformance.

(3) Initial Public Offerings (IPOs)

Initial public offerings are a fascinating and involved topic. The rules for new listings have changed over time, so we will cover only most relevant aspects of the history. For a more complete history, Li, Liu, Zhang, and Zhang (2020) is a good reference. As described in their paper, new IPOs have been suspended 9 times during periods of market volatility generally for a few months but once for over a year. In 2014, an unofficial guidance was put in place that capped IPO pricing to at most 23 times earnings. The intention was to protect investors who subscribe to an IPO, but more directly, it was a net transfer of wealth from the sellers of the firm shares to IPO subscribers. Most IPOs since then have been woefully underpriced. Initial IPO returns, which the paper defines as the cumulative returns up until the first day the stock doesn’t hit an upper pricing limit, averaged 150% in 2014, about 275% in 2015, and over 300% in 2016.

The STAR and GEM boards no longer have a limit on the price-to-earnings ratio of IPOs. This may indicate this rule will loosen over time for other boards as the CSRC often tests new regulations in a subset of stocks. In the meantime, getting in on China A-shares IPOs is very lucrative, but because of the depressed valuations, they are generally heavily oversubscribed. Note that Northbound Connect investors cannot subscribe to IPOs, but QFII investors can.

(4) Short selling and margin trading

Short selling and margin trading of individual stocks in the Chinese stock market were not allowed until March 2010, when the ban was lifted on a trial basis to improve market liquidity. It started with a highly selective list of only 90 stocks with good earnings performance and minimal volatility, but gradually expanded to about 800 stocks by September 2014. After the policy change, many investors ramped up their leverage through buying shares on margin, which was believed to greatly contribute to the 2015 stock market boom and bust. To stop the market from free falling, the CRSC took steps to discourage brokerage firms from short selling activities and crackdown on whom they deemed malicious short sellers.

Today, short selling and margin trading are allowed. In mid-2020, the CSRC significantly loosened the rules on who can lend shares, which led to a massive increase in short selling activity. However, it is still very expensive to short individual names and when compared to the United States, short selling levels are extremely low.

Another way to short a basket of China A-shares is through index futures and ETFs. You can short FTSE A50 futures which are traded in Singapore, but be warned that they are currency hedged to USD. This means that if you buy a basket of China A-shares which naturally are denominated in CNY and short Singapore’s FTSE A50 futures, you will be net long CNY. You would need to short CNH futures on the Chicago Mercantile Exchange (CME) or enter a short forward contract on CNH to hedge out the currency risk.

A much easier path is to short one of the many China A-shares index ETFs. They generally track an index such as CSI 300, FTSE A50, or MSCI China A. If you are looking to hedge your market risk, those are worth looking into, but make absolutely sure that if you are hedging China A-shares exposure, you use a China A-shares ETF and not a China, All China, or China All Shares ETF. If you hedge China A-shares using a general China ETF, you will have massive basis risk. Of course, index ETFs are also cheap ways of getting passive market exposure to China A-shares.

(5) Round lots

China imposes a uniform round lot requirement of 100 shares. That is, when you are buying stocks during trading sessions, each order must be in multiples of 100 shares. The same rule applies to selling, except since you can receive an odd lot number of shares from a share dividend, any remaining quantity less than 100 shares can be sold in a single order.

The round lot rule is only adopted is some countries. Currently it is predominately used in Asian countries, such as Thailand, the Philippines, and Taiwan. It is usually cheaper to trade round lots elsewhere in the world, but there is generally no explicit prohibition on trading odd lots as there is in China A-shares. Globally, the advent of electronic and online trading platforms has reduced, and in some cases eliminated, these odd-lot premiums. Some brokers such as Robinhood even allow fractional shares.

Among the countries that require a round lot to trade, the size of the unit varies: some countries impose the same size across the board while others base the size on other factors such as share price. For example, on the Taiwan Stock Exchange, the round lot size is 1000 shares across the board. On the Hong Kong Stock Exchange, the round lot size varies and is determined by the company’s board of directors.

Round lots do not change after a stock split, so splitting shares boosts liquidity and attracts smaller retail investors. For many Chinese A stocks, one round lot would take up a significant portion of an individual investor’s portfolio. For instance, Kweichow Moutai Co Ltd (ticker: 600519) closed at 2122.78 CNY at the end of February 2021. One lot of this stock amounts to 212,278 CNY (32,674 USD), no small sum for a typical retail investor.

The round lot size affects the portfolio management process too. First, it raises the hurdle of the minimum amount of invested capital to seed a new portfolio, especially when the portfolio has a non-trivial number of holdings. Second, it makes portfolio optimization for small portfolios a bit more complicated. Round lots turn the mapping of portfolio weights to utility from a convex surface into a set of discrete points. It is less restrictive for a large portfolio, but in small portfolios, stocks like Moutai can pose problems.

(6) Foreign Ownership Limits

There are two avenues to invest in China A-shares as a foreign investor: through a qualified foreign institutional investor (QFII) / Renminbi QFII (RQFII) quota and through the Shanghai/Shenzhen-Hong Kong Stock Connect program. QFII and RQFII requires the investor to be an institution and involves a non-trivial application process. However, it provides far greater flexibility in what one can invest in: A-shares, bonds, mutual funds, index futures, and IPO subscriptions.

The Stock Connect program is far easier but far less flexible. You can set up a Connect account with a brokerage in Hong Kong and invest in 1,472 China A-shares, which covers most large cap and mid cap stocks and a good number of small cap stocks. If you just want to invest in China A-shares, this is probably the way to go.

Foreign ownership in China A-shares is capped at 30%. As of February 2021, only 9 stocks have a foreign ownership over 24%. The biggest names are Midea Group (Ticker: 000333) with a market capitalization of about 630 billion RMB and about 24% foreign ownership and Gree Electric (Ticker: 000651) with a market capitalization of about 350 billion RMB and about 28% foreign ownership.

While not currently a significant issue, foreign ownership limits will become more relevant as China attracts more foreign flows. Moreover, as we will discuss in a later chapter, stocks with high foreign ownership tend to perform better, so stocks near their foreign ownership limit are exactly those you want to buy.

An Everchanging Landscape

The China A-shares market is only 30 years old. The regulatory and market environment is shifting gradually but constantly. The regulators are still adjusting, trying to find their preferred policy while reacting to the behavior of market participants.

When running backtests, we have to think about how the current regulatory environment might affect our strategies differently than historical periods. Most importantly, for the sake of our live portfolio and products, we have to stay abreast of the everchanging landscape. If the Shenzhen SME board merges into Shenzhen’s Main Board, that will not change our lives significantly. But if regulators limit the ability of firms to voluntarily suspend trading, suggest hastening the delisting process for ST firms, increase the ability of investors to lend shares, increase the price limit for ChiNext stocks, or change IPO pricing rules for ChiNext and STAR stocks, all of which they have done in the past few years, then our portfolios and approach can be affected.

What makes things even more difficult is that some rules such as the IPO pricing rules are not explicit. This requires not just reading the explicit regulations but speaking to those on the ground to discover the unwritten rules. It is a difficult problem, but that is exactly why we write these articles: to bring light to important issues that are far too easy to miss.