The Morningstar China Active/Passive Barometer November 2018

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1 The Morningstar China Active/Passive Barometer November 2018 Morningstar Manager Research, China November 2018 Rachel Wang Director of Manager Research, China Andy Huang, CFA Manager Research Analyst, China Executive Summary Welcome to the inaugural edition of the Morningstar China Active/Passive Barometer, a semiannual report that measures the performance of onshore China-domiciled active funds against their passive peers in their respective Morningstar Categories. It applies a similar methodology as Morningstar's U.S. Active/Passive Barometer and spans 946 unique active and passive China funds that account for approximately RMB 1.06 trillion (about USD billion) in assets. The Active/Passive Barometer uses several unique ways to measure active managers' success: It evaluates active funds not versus a costless index but against a composite of actual passive funds. In this way, the benchmark reflects the actual net-of-fee performance of passive funds. It assesses active funds based on their beginning-of-period category classification to better simulate the funds an investor would have had to choose from at the time. It considers how the average yuan invested in various types of active funds has fared versus the average yuan in the passive composite. All told, the Active/Passive Barometer is a useful measuring stick that can help investors better calibrate the odds of succeeding with active funds in different areas based on recent trends and long-term history. Key Takeaways This Active/Passive Barometer focuses on evaluating China-domiciled, actively managed broadly diversified stock-heavy funds (hereafter referred to as "China stock-heavy funds"), including funds in the equity, Shanghai-Hong Kong-Shenzhen equity, and aggressive-allocation categories but excluding any sector funds (in the health, technology, and communications sectors and any funds with over 50% of equity exposure in one sector or over 70% in any two sectors), since most passive strategies lie in the equity space in China. Furthermore, it is worth noting that funds in the equity, Shanghai-Hong Kong- Shenzhen equity, and aggressive-allocation categories invest at least 70% of their net assets in equities, and they have similar risk/return profiles. China onshore stock-pickers beat their average passive peers during the trailing one-, three-, five-, and 10-year periods we examined. We think this is in line with the emerging nature of the China A-share market, which mainly consists of retail participants. According to the annual statistics of the Shanghai Stock Exchange, China retail investors contributed 82.01% of trading volume in Therefore, active managers could more effectively generate alpha by exploiting the inefficiencies of the market. That said, active managers may find it more difficult to outperform index funds as the stock market matures over

2 Page 2 of 5 time. Another reason that could explain active funds' notable success rate in the equity space is active managers' flexibility in using cash positions. These managers tend to actively manage cash, especially when they feel the stock market is overheating or experiencing an extended market downturn. For example, some portfolio managers locked in profits when the China A-share market soared in the second quarter of 2015 and maintained a high-level cash position to function as a cushion in the subsequent market meltdown. The average yuan in actively managed stock-heavy funds has tended to outperform the average yuan invested in passively managed equity funds. The success rate of actively managed stock-heavy funds varies with distinct trailing periods. Over the decade ended in June 2018, 70.7% of active funds survived and outperformed their average passive peers. The trailing one-year success rate was the second-highest, with 69.1% of active funds beating their passive peers. At 54.4%, the five-year success rate of active funds was the lowest in the study, and one possible reason for that is active fund managers may have had difficulties in outperforming passive peers during the bull market between the second half of 2014 and the first half of The survivorship rate of active stock-heavy funds was typically higher than those of passive funds over the trailing one-, three-, and five-year periods. Active funds' high survivorship rate also contributed to a better active success ratio. The remarkably high survivorship rate for both China active stock-heavy funds (97% to 99% in the periods we studied) and passive funds (88% to 100% during the same period) could partially be explained by the fact that local fund companies have rarely chosen to liquidate their funds even if a fund's track record is unappealing, and few of these funds hit the regulatory minimum asset under management for liquidation (funds with net assets less than RMB 50 million). Investors have failed to choose above-average active stock-heavy funds. This is evidenced by the fact that active funds equal-weighted performance exceeded their asset-weighted performance during the trailing one-, three-, five-, and 10-year periods we examined. This study did not examine active funds' success by fee level, considering the insignificant fee differences among active funds in China. Exhibit 1 China Stock-Heavy Funds Active Funds #at Beginning of Period Rate (%) Passive Funds #at Beginning of Period Rate (%) Asset-Weighted Performance Active Passive (%) (%) Equal-Weighted Performance Active (%) Passive (%) Active Success Rate(%) Trailing Total Return 1-Year Trailing Year Trailing Year Trailing Year Trailing Source: Morningstar Direct. Data as of 30 June 2018.

3 Page 3 of 5 Appendix Methodology Data Source Morningstar's China open-end and exchange-traded funds database. Universe All ETFs and open-end mutual funds (excluding funds of funds and money market funds) in each Morningstar Category that existed at the beginning of the relevant period (including funds that did not survive to the end of the period) defined the eligible universe. To be included, the fund's inception date must precede the start of the period and the obsolete date cannot predate the start of the period. In addition, each must have asset data for at least one share class in the month prior to the start of the sample period (the beginning of the trailing one-, three-, five-, or 10-year period) to facilitate assetweighting. To calculate survivorship, we divide the number of distinct funds (based on unique fund ID at the beginning of the period) that started and ended the period in question by the total number of funds that existed at the onset of the period in question (the beginning of the trailing one-, three-, five-, or 10-year period). We treated China onshore-funds' transformation with a significant strategy change as a liquidation, since such funds will not track the prior performance record and will adopt a whole new strategy. In this case, the fund transformation date will be regarded as the end date of this fund. Asset-Weighted Returns We calculate the asset-weighted returns for each cohort using each share class' quarterly assets and returns since funds' assets are quarterly disclosed in China. When a fund becomes obsolete, its historical data remains in the sample. Funds that incept or migrate into the category after the start of the period are not included. Equal-Weighted Returns To come up with a single return figure for funds with multiple share classes, we first calculate the assetweighted average of all the fund s share classes. We then take the simple equal-weighted average of the quarterly returns for each fund in the group and compound those returns over the sample period. As before, when a fund becomes obsolete, its historical data remains in the sample. Funds that incept or are moved into the category after the start of the period are not included. Success Rate The success rate indicates what percentage of funds that started the sample period went on to survive and generate a return in excess of the equal-weighted average passive fund return over the period. This approach differs from the convention of using a single, representative index to gauge success. We do not consider magnitude of outperformance in defining success a fund that just barely beat the passive alternative counts as much as a fund that significantly outperformed. As in the equal-weighted return calculation, we calculate the asset-weighted average of all the fund s share classes to come up with a single return figure for funds with multiple share classes. We then rank the funds by their composite returns, count the number that rank higher than the equal-weighted average return for the passive funds in the category, and divide that number by the number of funds at

4 Page 4 of 5 the beginning of the period (using the same number from the denominator of the survivorship calculations). K

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