SH-HK Connect (Part 3): The quant perspective

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1 Strategy SH-HK Connect (Part 3): The quant perspective Quant-related implications for the A-share market Portfolio Strategy Research Impact of foreign investors to filter through in phases Changes in factor performance occurred in stages following the inclusion of the Korean and Taiwanese stock markets in the MSCI Emerging Markets (EM) Index. We believe the impending provision of mutual stock market access between Shanghai and Hong Kong will similarly affect factor performance in stages. Given the demonstrated effectiveness of profitability, valuation and other fundamental factors, we believe investment strategies based on these will be effective once foreign investors gain access. Gradual changes after opening up of Korea/Taiwan markets Retail investors exerted a strong influence on the Korean and Taiwanese stock markets prior to foreign investors gaining access, resulting in a strong near-term price mean reversion effect. Profitability and other factors were not especially strong before liberalization, but their effectiveness subsequently improved as share ownership by foreign investors and local institutional investors increased. Tsumugi Akiba +81(3) tsumugi.akiba@gs.com Goldman Sachs Japan Co., Ltd. Kinger Lau, CFA kinger.lau@gs.com Goldman Sachs (Asia) L.L.C. Timothy Moe, CFA timothy.moe@gs.com Goldman Sachs (Asia) L.L.C. Kathy Matsui +81(3) kathy.matsui@gs.com Goldman Sachs Japan Co., Ltd. Fundamental factors already effective in A market A key feature of the A-share market is the consistently strong nearterm price mean reversion effect irrespective of changes in shareholder composition. Operating profit growth is a highly effective factor, indicating that investors generally favor high-growth companies. Since 2011, profitability factors (ROE, ROA) have proven more effective as local institutional investors have gained prominence in the market. 1M reversal effect prominent in the A-share market currently Information coefficients (5-year average) Information Coefficient (5yr avg) 8% 6% 4% 2% 0% -2% -4% -6% 1M return 12M return FY0 P/E FY0 ROE A Korea Taiwan Source: Factset, Goldman Sachs Global Investment Research. Goldman Sachs does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. For Reg AC certification and other important disclosures, see the Disclosure Appendix, or go to Analysts employed by non-us affiliates are not registered/qualified as research analysts with FINRA in the U.S. The Goldman Sachs Group, Inc. Global Investment Research

2 Table of contents SH-HK Stock Connect: The quant perspective 3 Assessing the implications for A shares based on historical trends: Case study of Korea and Taiwan 4 Shareholder composition influenced both the Korean and Taiwanese markets 6 A factor performance: Price mean reversal highly effective, but fundamentals too 11 Conclusion: Foreign investors influence not imminent 15 Appendix: Impact of market liberalization in Korea and Taiwan 16 Disclosure Appendix 19 The author would like to thank Crystal Lu for her contribution to this report. Goldman Sachs Global Investment Research 2

3 SH-HK Stock Connect: The quant perspective Impact on A from greater foreign investor participation Our Strategy team has published two reports 1 on the SH-HK Connect Scheme, whereby mutual stock market access will be established between Shanghai and Hong Kong. The scheme will open up the Hong Kong market to mainland Chinese institutional investors and some retail investors 2, and the A-share market to Hong Kong and foreign institutional/retail investors. Until now, only qualified foreign institutional investors (QFIIs) or RMB QFIIs (RQFIIs) have been able to invest in A shares. The impending move can be seen as part of the government s attempt to open up the Chinese economy, and will likely be welcomed by foreign investors who have so far been excluded from investing in A shares. The scheme should also allow some of s estimated Rmb48 tn ( 800 tn) in personal savings to flow into the Hong Kong stock market, in our view. We therefore expect mutual benefits for mainland Chinese and foreign investors. In this report: We examine how factor effectiveness changed before and after the Korean and Taiwanese markets were liberalized to allow foreign investors; We perform a comprehensive analysis to determine which factors have been effective since January 2001 in the A-share market, compare our findings with the Korea/Taiwan cases, and propose investment strategies. Our analysis produced the following results: Near-term price mean reversion was highly effective in the Korean and Taiwanese markets before they were opened up to foreign investors, reflecting the heavy influence of retail investors. Profitability and other factors that provide a long-term source of alpha were not especially effective before market liberalization, but their effectiveness improved as the weighting of foreign investors and domestic institutional investors increased. In the early 2000s, near-term price mean reversion also proved effective in the A- share market, again due to the strong influence of retail investors. Operating profit growth was another effective factor, reflecting the tendency for investors to favor highgrowth companies. We also believe the debt/equity (D/E) ratio and similar indicators will gain importance against the backdrop of debt default caused by companies in a negative net worth position in a slowing Chinese economy. The effectiveness of profitability factors (ROE, ROA) have improved since 2011 as local institutional investors have gained greater influence in the market. Since 2011, A shares have exhibited a similar set of factors that worked well in Korea and Taiwan. Our results highlight a similar set of factors as an effective stock selection strategy. 1 SH-HK Connect: New regime, unprecedented opportunity (September 1, 2014), and SH-HK Connect (Part 2): Trading the A- H convergence (September 22, 2014). 2 Mainland Chinese retail investors with a combined Rmb500,000 or more in securities/cash accounts. Goldman Sachs Global Investment Research 3

4 Assessing the implications for A shares based on historical trends: Case study of Korea and Taiwan To measure the impact of the A-share market opening up to direct purchases by foreign investors, we perform a factor analysis of the Korean and Taiwanese markets, which were introduced to the MSCI Emerging Markets (EM) Index in stages. Markets in Taiwan and Korea were opened up to foreign investors for direct investment in 1991 and 1992, respectively. Korea was added to the MSCI EM Index from January 1992 (at a 20% inclusion factor) and Taiwan from September 1996 (50% IF), with full inclusion taking place in 1998 for Korea and 2005 for Taiwan. The Appendix section details our Strategy team s analysis of the impact on the two markets as a whole from their MSCI EM inclusion. In this section, we examine changes in factor effectiveness before and after Korea and Taiwan allowed foreign investors to purchase shares directly. We focus specifically on the factor effectiveness at the time of their MSCI EM inclusion. We look at the period after both Korea and Taiwan were added to the MSCI EM Index with a 50% IF in September 1996, and the period after full inclusion (September 1998 for Korea, June 2005 for Taiwan). The factor groupings examined are: (1) value, (2) growth, (3) profitability/financial health, and (4) share price returns. Method of analysis: Our sample period for analysis varies slightly for Korea and Taiwan because they were included in the MSCI EM Index at different points in time. We nonetheless use the same conditions for measuring factor effectiveness in both markets, as detailed below. Factor scores are based on available data at the time (e.g., we apply a 3-month lag to reflect the release of actual data). Period of analysis: January 1990 August 2014 for Korea, January 1992 August 2014 for Taiwan. Universe: For both Korea and Taiwan, our universe for the period prior to full MSCI EM inclusion comprises companies with a market cap of at least US$500 mn. Our universe for the period after full inclusion also comprises companies with a market cap of at least US$500 mn through December 2005, and MSCI EM constituent stocks in both markets from January 2006 onward. Frequency: Monthly. Method of measuring factor effectiveness: Sector-adjusted information coefficients (ICs), information ratios (IRs). See Appendix for a detailed explanation of how we measure factor effectiveness. Below, we summarize the results of our analysis. 1. Effective factors before MSCI EM inclusion and their characteristics Korean market: Sales and operating profit growth factors showed relatively strong predictive power in terms of excess return forecast, while 1- and 3-month share price returns produced a strong near-term price mean reversion effect. The D/E ratio factor generated a negative return, indicating that investors generally favored stocks with higher leverage over stocks with little or no leverage. Goldman Sachs Global Investment Research 4

5 Taiwanese market: Like in the Korean market, share price returns produced a strong price mean reversion effect, with all performing negatively over 1-, 3- and 6-month timeframes. Value factors had little effect, while dividend yield produced a negative return, indicating that high dividend yield stocks underperformed and stocks offering few or no dividends outperformed. Growth factors were positive, indicating a preference for growth over dividends. Financial health and profitability factors such as D/E ratio, ROE and ROA were ineffective for stock picking. 2. Effective factors after MSCI EM inclusion and their characteristics Korean market: P/E factor improved markedly after Korea s IF for the MSCI EM Index rose to 50% in September We observed several changes in factor effectiveness following its full inclusion in September First, the near-term (1- and 3-month) price mean reversion effect weakened, while longer-term 12- and 24-month share price momentum factors predictive power turned from negative to positive. Dividend yield also became an effective factor, and the effectiveness of D/E, ROE and ROA in stock picking improved markedly. Taiwanese market: Like the Korean market, a clearer trend was evident after full MSCI EM inclusion. The price mean reversion effect from near-term (1- and 3-month) share price returns weakened after June 2005, while 6- and 12-month price momentum became more effective. 24-month momentum also turned positive but was less effective than 6- and 12- month horizons. Among value factors, the effectiveness of P/E and dividend yield in stock picking improved substantially, with the IR especially high for dividend yield. At the time, dividend yield was a factor that produced a stable effect with a high average IC and low IC standard deviation. ROE and ROA effectiveness improved significantly after inclusion, but there was no major change in D/E performance. 3. Effective factors throughout sample period, irrespective of MSCI EM inclusion In both the Korean and Taiwanese markets, the factor effectiveness of operating profit growth was more or less unchanged before and after MSCI EM inclusion. Investors, regardless of type, tend to favor high growth stocks in both markets. On the other hand, P/B produced limited effect before and after inclusion. This indicates investors in those markets tend to pay less attention to P/B levels. Exhibit 1: Strong reversal effect weakened over time in Korea Factor performance in Korea Exhibit 2: Similar changes occurred in Taiwan Factor performance in Taiwan IR 0.6 IR M return 3M return 6M return 12M return 24M return M return 3M return 6M return 12M return 24M return 1/90 to 12/91 1/92 to 8/96 9/96 to 8/98 9/98 to 12/07 1/08 to 8/14 1/92 to 8/96 9/96 to 5/05 6/05 to 8/14 Source: Goldman Sachs Global Investment Research. Source: Goldman Sachs Global Investment Research. Goldman Sachs Global Investment Research 5

6 Exhibit 3: P/E and dividend yield improved gradually in Korea Factor performance in Korea Exhibit 4: P/E and dividend yield were also effective in Taiwan Factor performance in Taiwan IR IR FY0 P/E FY0 P/B FY0 Div yield Sales growth OP growth YoY YoY 1/90 to 12/91 1/92 to 8/96 9/96 to 8/98 9/98 to 12/07 1/08 to 8/ FY0 P/E FY0 P/B FY0 Div yield Sales growth YoY 1/92 to 8/96 9/96 to 5/05 6/05 to 8/14 OP growth YoY Source: Goldman Sachs Global Investment Research. Source: Goldman Sachs Global Investment Research. Exhibit 5: D/E, ROE and ROA have all turned effective since September 1998 in Korea Factor performance in Korea Exhibit 6: ROE and ROA are now effective factors in Taiwan Factor performance in Taiwan IR IR FY0 D/E FY0 ROE FY0 ROA FY0 D/E FY0 ROE FY0 ROA 1/90 to 12/91 1/92 to 8/96 9/96 to 8/98 9/98 to 12/07 1/08 to 8/14 1/92 to 8/96 9/96 to 5/05 6/05 to 8/14 Source: Goldman Sachs Global Investment Research. Source: Goldman Sachs Global Investment Research. Shareholder composition influenced both the Korean and Taiwanese markets One common trait we have observed in both the Korean and Taiwanese markets was the strong price mean reversion effect before liberalization to allow foreign investors (i.e., the point of MSCI EM inclusion). Price mean reversion was particularly effective over 1- and 3- month near-term timeframes. After inclusion, the near-term return-reversal effect weakened in both markets. We identify shareholder composition as one factor behind the near-term price mean reversion effect. In particular, the weighting of retail investors was high in both the Korean and Taiwanese stock markets before foreign investors were allowed to enter (see Exhibits 10-11). High retail investor participation tends to be associated with the herding effect, where investors generally behave similarly and tend to Goldman Sachs Global Investment Research 6

7 over-react causing a strong mean reversion effect 3. Retail investors also tend to be highly speculative and have relatively short investment horizon. In Korea, retail investors share ownership ratio exceeded 70% in the 1980s. Although it declined in the 1990s as the weighting of local Korean institutional investors rose, it nevertheless remains at around 40%. The share ownership ratio of foreign investors increased at a modest pace through 2004 following MSCI EM inclusion, in part owing to the 1997 Asian currency crisis. At one point, it surpassed 20% but at present it stands at about 15%. In Taiwan, retail investors accounted for around 50% of share ownership from the 1990s through the early 2000s. Following Taiwan s full MSCI EM inclusion in 2005, the foreign investor ownership ratio increased gradually and today trends between 20% and 30%. So what we see is a strong near-term price mean reversion effect in Korea and Taiwan where share ownership by retail investors was high. We believe this correlation with shareholder composition was a key factor. Various research publications have examined the trading patterns of retail investors 4 and have pointed to a strong psychological anomaly known as the disposition effect in behavioral finance. The disposition effect refers to the tendency for investors to sell winning stocks too soon and hold on to losing stocks for too long due to fear of regret and to preserve their dignity. While holding on to losing stocks for too long has no direct impact on return-reversal, selling winning stocks too soon amplifies the near-term return-reversal effect. The impact of margin trading repayment deadlines also warrants consideration. Both Korean and Taiwan have 6-month deadlines that we believe may encourage short-term trading activity, thereby influencing the nearterm return-reversal effect. Markets in which retail investors exert a large influence often tend to encounter herding, another anomaly in behavioral finance. Herding refers to investment strategies and investment patterns converging as market participants think and act in the same way as the majority. Retail investors tend to have a shorter investment horizon and often it is more important for them to see how other market participants forecast near-term share price movements and take action than focus on the intrinsic or fundamental value of a stock. As such, when one investor takes action on a particular theme or stock (and the share price moves), it often serves as a signal for other investors to follow suit. This increases the tendency for market participants to herd together in terms of investment strategies and investment patterns. Meanwhile, since this phenomenon occurs frequently, each individual trend tends to be short lived, amplifying the near-term return-reversal effect. Exhibits 7-8 show the 10 most actively traded stocks ratio (i.e., ratio of the value traded for the 10 most active stocks over the value traded for the entire market) for Korean and Taiwan. These stocks were traded more actively before market liberalization in the two markets, but both ratios have declined notably since The 10 most actively traded stocks ratio indicates how concentrated trading activities were at that point in time, a proxy for the herding effect. We acknowledge that the Korean and Taiwanese markets have grown meaningfully in both breadth and depth over time, and the ratio of the 10 most actively traded stocks should naturally come down. However, by comparing the ratio to historical average and standard deviation, we should get an indication of how concentrated or not the trading activities are. 3 Chang et al found significant evidence of herding in South Korea and Taiwan. Chang, E.C., Cheng, J.W., & Khorana, A. (2000). An examination of herd behavior in equity markets: An international perspective. Journal of Banking & Finance, Kaniel, Ron, Gideon Saar, and Sheridan Titman Individual Investor Trading and Stock Returns. Journal of Finance 63:1. Goldman Sachs Global Investment Research 7

8 Exhibit 7: Trades in Korea were concentrated before liberalization Ratio of 10 most actively traded to total Korea Exhibit 8: Similar trend in Taiwan Ratio of 10 most actively traded to total Taiwan 75% 65% 55% 45% 60% 50% 40% 30% 35% 20% 25% 12/95 12/97 12/99 12/01 12/03 12/05 12/07 12/09 12/11 12/13 Korea 12M mav +2σ -2σ 10% 12/95 12/97 12/99 12/01 12/03 12/05 12/07 12/09 12/11 12/13 Taiwan 12M mav +2σ -2σ σ Source: Goldman Sachs Global Investment Research. Source: Goldman Sachs Global Investment Research. A similar trend exists in the A-share market. The 10 most actively traded stocks ratio was comparatively high in the early 2000s, when the share ownership ratio of retail investors exceeded 90%, suggesting herding similar to that seen in the Korean and Taiwanese markets. Thereafter, growth in the number of local Chinese institutional investors led to a marked decline in the 10 most actively traded stocks ratio. Once the reciprocal trading of Shanghai and Hong Kong shares begins on the two markets and foreign investors gradually move into A shares, we expect the impact of herding to diminish and the near-term return-reversal effect to wane. Exhibit 9: The trade concentration ratio has been declining gradually in A shares Ratio of 10 most actively traded to total A-share market 45% 40% 35% 30% 25% 20% 15% 10% 5% 1/01 1/03 1/05 1/07 1/09 1/11 1/13 A 12M mav +2σ -2σ Source: Goldman Sachs Global Investment Research. Goldman Sachs Global Investment Research 8

9 Exhibit 10: Retail investors share ownership declined from around 2000 as ownership by foreign investors and local institutional investors rose Share ownership in the Korean stock market by investor category 100% Full inclusion in MSCI EM 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Domestic Individual Government Agency Domestic Financial institutions Domestic Corporation Foreigners *Ownership based on number of shares. Source: KSE, CEIC, Goldman Sachs Global Investment Research. Goldman Sachs Global Investment Research 9

10 Exhibit 11: Foreign investors share ownership ratio surpassed 20% after full MSCI EM inclusion in 2005 and has been stable since Share ownership in the Taiwanese stock market by investor category 100% Full inclusion in MSCI EM 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Domestic Individual Government Agency Domestic Financial institutions Domestic Corporation Foreigners *Ownership based on number of shares. Source: TWSE, CEIC, Goldman Sachs Global Investment Research. Goldman Sachs Global Investment Research 10

11 Exhibit 12: Retail investors share ownership ratio has halved in the last decade, while the ratio of local institutional investors is on the rise Share ownership in the A-share market by investor category 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Q Retail Investors Local Institutional Investors Foreign Institutional Investors (QFII) *Ownership based on value of shares. Source: Wind, Goldman Sachs Global Investment Research. A factor performance: Price mean reversal highly effective, but fundamentals too We believe A shares will exert considerable influence once included in global equity market benchmarks. The weighting of A shares in global equity benchmarks (e.g., the MSCI) is conspicuously low considering the current size of the Chinese economy. Structurally, A shares are under-represented. s GDP accounted for approximately 12.3% of global GDP in 2013, 11.3% of global trade in value terms, and 7.9% of global consumption, yet the weighting of the MSCI Index in the MSCI AC World Index is a mere 2.2%. If A shares are included in MSCI s global indexes, our Strategy team calculates buying demand from passive funds of around US$5.3 bn/us$21.0 bn (based on IFs of 5% and 20%). We conduct a factor effectiveness analysis on A shares to predict future factor trends. The factor groupings examined are: (1) value, (2) growth, (3) profitability/financial health, and (4) share price returns, the same as those for the Korean and Taiwanese markets. Method of analysis: We use the conditions detailed below for measuring factor effectiveness. Factor scores are based on available data at the time (e.g., we apply a 3-month lag to reflect the release of actual data). Goldman Sachs Global Investment Research 11

12 Period of analysis: January 2001 August Universe: Our universe up to May 2007 comprises companies with a market cap of at least US$500 mn, and companies with a market cap of at least US$1 bn from May Frequency: Monthly; factor scores are sector neutral. Method of measuring factor effectiveness: Sector-adjusted ICs, IRs. Below, we summarize the results of our analysis. (1) Value: The dividend yield factor had the highest IR. The average IC for dividend yield was lower than that for actual P/E in both periods, but dividend yield had a low IC standard deviation and was a stable alpha-generating factor. Both dividend yield and actual P/E performed slightly better from Retail investors and local Chinese investors alike have consistently shown a tendency to prefer stocks offering high dividends. At the same time, both retail investors and domestic institutions tend to avoid non-dividend paying stocks. This is apparent from their underperformance as shown in Exhibit 14. It is also interesting to note that the low dividend yield stocks have outperformed high dividend yield stocks. As with other factors, factors go in and out of favor over time and it is important to understand both the historical trend and the recent trend. Conversely, P/B demonstrated less stockpicking effectiveness as an alpha factor than P/E and dividend yield. P/B s average IC was relatively high, but with its high IC standard deviation it cannot be regarded as a stable factor, in our view. (2) Growth: Companies with high yoy operating profit growth were highly evaluated by the market, whereas companies with low or negative growth tended to underperform. The IR was high for the operating profit growth factor, indicating stable stock-picking effectiveness. Since 2011, when local institutional investors share ownership ratio increased in, the IR has risen as market participants have clearly favored high-growth stocks. On the other hand, the alpha generating ability and predictive power of the sales growth factor have not been that high. This suggests a tendency for both retail investors and local institutional investors to eschew growth driven simply by the top line. Sales growth factor effectiveness has been declining, albeit slightly, since 2011 when the share ownership ratio of institutional investors increased. (3) Profitability/financial health: Return predictive power for ROE, ROA and D/E was not high in periods when retail investors had a strong market influence. However, ROE and ROA showed greater effectiveness as local institutional investors share ownership ratio increased. This shows that investors adopted a strategy of picking companies with high profitability and ignored those with low profitability. At the same time, D/E effectiveness seems to have been little influenced by changes in shareholder composition. We think defaults of late by companies falling into negative net worth as a result of the slowing Chinese economy will increase debt default risk. Since the default problem broadly extends to debt issued by companies under the umbrella of local governments and not just corporate bonds, we believe indicators such as D/E will grow in importance. (4) Share price returns: The near-term return-reversal effect (1- and 3-month) is very strong. This tendency does not appear to be influenced that much by shareholder composition. That said, longer-term return-reversal (12- and 24-month) appears to have increased in effectiveness as the share ownership ratio of institutional investors has risen. We think long-term share-price momentum will become a more effective factor as the influence of foreign and local institutional investors strengthens in the A-share market, as was the case in Korea and Taiwan. We see little prospect of a dramatic decline in the near-term return-reversal effect in the A-share market, as this factor is evident to some extent in other developed markets and emerging markets. Goldman Sachs Global Investment Research 12

13 Exhibit 13: Operating profit growth and dividend yield were highly effective Information ratios by factor IR FY0 P/E FY0 P/B FY0 Div yield Sales growth YoY 2002 to 12/10 1/2011 to 8/14 OP growth YoY Source: Factset, Goldman Sachs Global Investment Research. Exhibit 14: Investors in the A-share market tend to avoid non-dividend paying stocks Quintile dividend yield factor performance /09 1/11 1/13 Q1 (High Yield) Q2 Q3 Q4 Q5 (Low Yield) No Div Source: Factset, Goldman Sachs Global Investment Research. Goldman Sachs Global Investment Research 13

14 Exhibit 15: ROE and ROA are turning more effective following rise in share ownership ratio of institutional investors Information ratios by factor IR FY0 D/E FY0 ROE FY0 ROA 2002 to 12/10 1/2011 to 8/14 Source: Factset, Goldman Sachs Global Investment Research. Exhibit 16: Strong near-term return-reversal effect Information ratios by factor IR M return 3M return 6M return 12M return 24M return 2002 to 12/10 1/2011 to 8/14 Source: Factset, Goldman Sachs Global Investment Research. Goldman Sachs Global Investment Research 14

15 Exhibit 17: Preference for factors with a high average IC and low standard deviation Factor performance Average Information Coefficient Information Ratio Standard Deviation 1/02 to 12/10 1/11 to 8/14 1/02 to 12/10 1/11 to 8/14 1/02 to 12/10 1/11 to 8/14 1M return -5.3% -4.3% % 15.0% 3M return -4.6% -4.8% % 18.5% 6M return -1.3% -3.5% % 19.6% 12M return 0.2% 2.2% % 21.8% 24M return 0.5% 1.0% % 20.4% FY0 P/E 2.9% 3.9% % 18.2% FY0 P/B 2.2% 2.2% % 22.7% FY0 Div yield 2.6% 3.7% % 14.1% Sales growthyoy 1.2% 0.8% % 9.5% OP growthyoy 3.3% 3.2% % 11.4% FY0 D/E 1.1% 2.4% % 15.7% FY0 ROE 5.0% 4.6% % 12.7% FY0 ROA 4.3% 4.0% % 14.2% Source: Factset, Goldman Sachs Global Investment Research. Conclusion: Foreign investors influence not imminent We see limited impact on factor performance once the SH-HK mutual stock market access kicks off, given liberalization of the Korean and Taiwanese markets for foreign investors and changes in factor performance after inclusion in the MSCI EM Index occurred in stages. Furthermore, we think foreign investors are likely to adopt essentially the same investment strategy when they enter the A-share market. A shares already exhibit a similar set of factors that worked well in Korean and Taiwan. The similar factor strength that we observe in all three markets could be that many of the domestic investors in have learnt effective investment strategies from overseas markets. Therefore, a marked change in factor effectiveness is unlikely given the influence of local institutional investors will also strengthen and fundamentals factor groupings such as profitability and valuation have already proven effective as alpha factors. However, as per the Korean and Taiwanese markets, we note that the near-term (1- and 3-month) price mean reversion effect may weaken somewhat due to the entry of foreign investors. We also believe the D/E ratio and similar indicators will gain importance against the backdrop of debt default caused by companies in a negative net worth position in a slowing Chinese economy. We believe an investment strategy that marries these elements will prove effective in the A-share market. Goldman Sachs Global Investment Research 15

16 Appendix: Impact of market liberalization in Korea and Taiwan This section is an extract from our Strategy team s previous report SH-HK Connect: New regime, unprecedented opportunity, dated September 1, We examine two important events allowance of direct foreign participation in local equity market (e.g. QFII), and MSCI EM inclusion in Korea s and Taiwan s respective market liberalization processes, which may shed light on what may take place in in the next few years. Market returns: Korea and Taiwan allowed foreign investors to directly purchase domestic equities in 1992 and 1991 respectively subject to specific regulations. In the same year, Korea was admitted to the MSCI EM universe and Taiwan was added in These two events appeared to have limited return impact on Korea while Taiwan enjoyed a strong rally (and outperformance) on these catalysts. Valuations: Taiwan s rally was primarily fuelled by multiple expansion, and we note there was similar re-rating in Korea, although it was short-lived and lasted for only 1-2 months. Turnover velocity: We note there were meaningful increases in turnover velocity in all the three episodes but the rise in trading activity only sustained for 2-3 months, possibly reflecting investors initial excitement about the market liberalization developments. Volatility: Volatility rose significantly before the QFII implementation in Taiwan but subsequently normalized. In the other two cases, volatility remained largely stable around the events. Return correlation: Contrary to common perception, the opening up of these two markets didn t introduce higher return correlation with global equities (we use MXAPJ as a proxy). We think this reflects the positioning shifts of domestic investors in anticipation of the liberalization measures, and the lagged effects between the opening up and actual implementation by foreign investors when they enter into a new market. Goldman Sachs Global Investment Research 16

17 Exhibit 18: Taiwan rallied on its market liberalization events Exhibit 19: and the returns were mainly driven by valuation expansion Rebased price index (LOC) (event dates = 100) KOSPI (First time EM inclusion) TWSE (First time QFII) Months before/after market liberalization events Source: Factset, Goldman Sachs Global Investment Research. TWSE (First time EM inclusion) f-12m P/E (X) MXTW (First time QFII) MXTW (First time EM inclusion) MXKR (First time EM inclusion) Months before/after market liberalization events Source: Datastream, I/B/E/S, MSCI, Goldman Sachs Global Investment Research. Exhibit 20: Turnover velocity rose immediately post these market events but normalized thereafter Exhibit 21: Volatility decreased after Taiwan implemented the QFII system Annualized turnover velocity, 3M moving average 6 TWSE TWSE (First time EM 5 (First time QFII) inclusion) 4 Annualized volatility, rolling 260D 70% 60% 50% TWSE (First time QFII) % 30% KOSPI (First time EM inclusion) 1 0 KOSPI (First time EM inclusion) Months before/after market liberalization events Source: TWSE, KSE, WFE, CEIC, Goldman Sachs Global Investment Research. 20% 10% TWSE (First time EM inclusion) Months before/after market liberalization events Source: Factset, Goldman Sachs Global Investment Research. Exhibit 22: Empirically, market return correlations with global equities didn t rise post events Exhibit 23: Foreign investors generally have high market impact on most Asian bourses Monthly price (US$) correlation vs. MXAPJ, rolling 2 years 0.8 TWSE 0.6 (First time EM inclusion) 0.4 Rolling 5Y monthly correl. (net foregin inflows vs. market returns) 1.0 Korea Taiwan India ASEAN Japan TWSE (First time QFII) KOSPI (First time EM inclusion) Months before/after market liberalization events Aug-09 Feb-10 Aug-10 Feb-11 Aug-11 Current foreign ownership (%) KR TW IN TH PH JP CN 34% 37% 21% 19% 23% 31% 3% Feb-12 Aug-12 Feb-13 Aug-13 Feb-14 Aug-14 Source: Factset, MSCI, Goldman Sachs Global Investment Research. Source: Bloomberg, Local stock exchanges, Goldman Sachs Global Investment Research. Goldman Sachs Global Investment Research 17

18 Factor performance measurement methodology At the end of every month, we calculate a sector-adjusted factor score for every stock and rank stocks based on these scores. At the end of the following month, we rank stocks based on their total return for the month. We measure the correlation between these two rankings every month. We then analyze information coefficient (IC) time series data calculated in this way. Should a factor have the ability to explain the return in full, it has an IC rank of 1. Based on monthly time series data, if a factor has: (1) a high average IC, (2) low IC volatility, and (3) is consistently positive or negative, it is deemed to be highly effective (have strong predictive power) and therefore useful for a stock-picking model. Interpretation of IC rank The expected return generated by the factor tilt is shown by the following formula: Expected return = IC volatility factor exposure; where volatility = standard deviation of monthly cross section returns. Assuming an average monthly volatility for the entire universe of 7.5% and an average IC of 3.5% for factor X, the expected return (annualized) for a one standard deviation factor exposure is calculated as follows: 3.5% 7.5% 1 12 = 3.15% Therefore, the expected return (annualized) for a one standard deviation factor exposure is 3.15%. MSCI disclosure All MSCI data used in this report is the exclusive property of MSCI, Inc. (MSCI). Without prior written permission of MSCI, this information and any other MSCI intellectual property may not be reproduced or redisseminated in any form and may not be used to create any financial instruments or products or any indices. This information is provided on an as is basis, and the user of this information assumes the entire risk of any use made of this information. Neither MSCI, any of its affiliates nor any third party involved in, or related to, computing or compiling the data makes any express or implied warranties or representations with respect to this information (or the results to be obtained by the use thereof), and MSCI, its affiliates and any such third party hereby expressly disclaim all warranties of originality, accuracy, completeness, merchantability or fitness for a particular purpose with respect to any of this information. Without limiting any of the foregoing, in no event shall MSCI, any of its affiliates or any third party involved in, or related to, computing or compiling the data have any liability for any direct, indirect, special, punitive, consequential or any other damages (including lost profits) even if notified of the possibility of such damages. MSCI and the MSCI indexes are service marks of MSCI and its affiliates. The Global Industry Classification Standard (GICS) were developed by and is the exclusive property of MSCI and Standard & Poor s. GICS is a service mark of MSCI and S&P and has been licensed for use by The Goldman Sachs Group, Inc. Goldman Sachs Global Investment Research 18

19 Disclosure Appendix Reg AC We, Tsumugi Akiba, Kinger Lau, CFA and Timothy Moe, CFA, hereby certify that all of the views expressed in this report accurately reflect our personal views about the subject company or companies and its or their securities. We also certify that no part of our compensation was, is or will be, directly or indirectly, related to the specific recommendations or views expressed in this report. Disclosures Distribution of ratings/investment banking relationships Goldman Sachs Investment Research global coverage universe Rating Distribution Investment Banking Relationships Buy Hold Sell Buy Hold Sell Global 32% 54% 14% 42% 36% 30% As of July 1, 2014, Goldman Sachs Global Investment Research had investment ratings on 3,697 equity securities. Goldman Sachs assigns stocks as Buys and Sells on various regional Investment Lists; stocks not so assigned are deemed Neutral. 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20 Ratings, coverage groups and views and related definitions Buy (B), Neutral (N), Sell (S) -Analysts recommend stocks as Buys or Sells for inclusion on various regional Investment Lists. Being assigned a Buy or Sell on an Investment List is determined by a stock's return potential relative to its coverage group as described below. Any stock not assigned as a Buy or a Sell on an Investment List is deemed Neutral. Each regional Investment Review Committee manages various regional Investment Lists to a global guideline of 25%-35% of stocks as Buy and 10%-15% of stocks as Sell; however, the distribution of Buys and Sells in any particular coverage group may vary as determined by the regional Investment Review Committee. Regional Conviction Buy and Sell lists represent investment recommendations focused on either the size of the potential return or the likelihood of the realization of the return. Return potential represents the price differential between the current share price and the price target expected during the time horizon associated with the price target. Price targets are required for all covered stocks. The return potential, price target and associated time horizon are stated in each report adding or reiterating an Investment List membership. Coverage groups and views: A list of all stocks in each coverage group is available by primary analyst, stock and coverage group at The analyst assigns one of the following coverage views which represents the analyst's investment outlook on the coverage group relative to the group's historical fundamentals and/or valuation. Attractive (A). The investment outlook over the following 12 months is favorable relative to the coverage group's historical fundamentals and/or valuation. Neutral (N). The investment outlook over the following 12 months is neutral relative to the coverage group's historical fundamentals and/or valuation. 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