Understanding Emerging Market Equity Mutual Funds: The Case of China (2011)

Abstract Investing in emerging equity markets is always a challenge to individual investors, even though the growth potential of these markets is attractive because of their fast economic development. This paper contributes to individual investment by investigating the characteristics of the Chinese stock market through a study of the Chinese equity funds. We find these Chinese funds outperform the stock market benchmark significantly with their Sharpe ratio values; but when performance is measured by asset pricing models, the evidence fades. In addition, larger funds outperform small or medium sized funds, regardless of the model and measurement selection. Our results suggest individual investors should favor actively managed equity funds when total-risk adjusted return is a concern and they should choose indexed funds if market-risk adjusted return is the objective. Investors should generally prefer larger equity funds over smaller funds when investing in the Chinese stock market. © 2011 Academy of Financial Services. All rights reserved. JEL classification: G12; G15 Keywords: Mutual fund performance; Emerging markets (ProQuest: ... denotes formulae omitted.) 1. Introduction More and more individual investors now realize that they are living in a global economy and their investment universe is no longer their home country or just the developed countries. Following the action of institutional investors, they must give greater attention to the emerging markets, especially those with robust economic growth potential such as China. The rapid growth of the GDP shares of emerging markets makes a strong argument for higher asset allocation in these countries (El-Erian 2008). On the other hand, individual investors often do not have the support of a capital intensive R&D department or sophisticated empirical modeling. It is easy for investors to get lost in the large amount of market data and the number of financial products offered by the financial industry. A greater understanding of emerging markets becomes a critical task for individual investors. This paper fills the gap by investigating the characteristics of Chinese equity mutual funds. Becoming one of the most prosperous countries in the last few decades, China surpassed Japan to become the second largest economy by GDP in 2010 (IMF data). The annual nominal GDP compound growth rate in Chinese currency was 14.3%, 14.0%, and 9.9% for the periods 1980-2010, 1990-2010, and 2000-2010, respectively. The compound GDP growth rate in the United States for the same periods was 5.7%, 4.7%, and 3.8%, respectively (Bureau of Economic Analysis). The Chinese stock market started from a few Usted companies in the early 1990s to about two thousand companies in 2010. The Chinese mutual fund industry also prospered during this period. There were only 49 closed-end funds in China when the first open-end fund was created in September 2001. Open-end funds have experienced more rapid growth than closed-end funds, especially since the Law of the People's Republic of China on Securities Investment Fund was enacted in November 2003. By March 2008, the total number of both funds had risen to 392, with 357 (91%) of them being open-end funds. The mutual fund industry had USD 468 billion under management of which 94% were in open-end funds. Open-end funds have dominated the Chinese mutual fund market by both the number of the funds and the value of their assets under management (AUM) since late 2003. The number of closed-end funds has declined since 2006 with some of the closed-end funds changing their status to open-end funds to attract business. Our focus on equity mutual funds (open-end) meets the investment needs of individual investors because it is almost impossible for them to research individual Chinese stocks that operate under a different accounting and legal environment. Equity mutual funds may also help diversify firm-specific risk. …