The bank had a "significant overweight" on China going into 2015, based on the opening of the A-share market and other measures to open the financial industry, he said.
However, in April the bank cut exposure to Asia -- predominantly China -- by 60% in its balanced portfolio to underweight the region, he said.
“We’ve maintained that underweight through today and haven’t considered going back to an overweight yet,” Doherty told Fund Selector Asia.
China sell trigger
Doherty said the bank didn't predict the stock market turmoil that began in June. But concern grew based on meetings earlier in the year with two hedge funds, one based in China who long maintained positive views on the mainland and the other based in New York, with a long-held negative view.
Their divergent opinions overlapped on one key issue: both believed currency devaluation would happen.
"We ask from a fund that is investing in Asia not to be constrained, not benchmark aware, as agnostic as possible. A benchmark is effectively backward looking"
“Those contrasting views met in the middle and that’s something we pay attention to,” Doherty said.
Moreover, the devaluation concern coincided with an increasingly strong mainland stock market performance that looked like a classic boom-bust cycle, he said. “We thought it best to take money off table and did not reallocate back to equities. The majority [of reallocated capital] went into hedge funds.”
He added that the firm was surprised when China’s plunging markets roiled global markets.
“We didn’t expect that reaction from the international investment community.”
Two Asia funds
Folllowing the Taper Tantrum in late 2013, Arbuthnot consolidated holdings from three Asia funds that were slightly different into one vehicle, the BlackRock Asian Growth Leaders Fund.
Although it has been in the fund for two years, its holdings have changed significantly this year due to the large reduction in China exposure.
Doherty said he likes the fact that the fund’s investments follow initiatives and policies the government is trying to pursue.
“We ask from a fund that is investing in Asia not to be constrained, not benchmark aware, as agnostic as possible. A benchmark is effectively backward looking because the companies [it includes] would have been successful in the past, such as industrials. That’s not the future of China. It would be on the consumer side, or areas the government is supporting, and that’s what this fund does."
The bank is overweight India equities and it has separated India out from the rest of Asia through a country fund, the HSBC India Equities Fund.
“The Indian market is expensive but there is potential for real earnings in the future. Reforms are not at the pace the market would like them to be, but we believe they will progress and earnings will get revised upwards.
“The India picture is completely different to China. The two are moving almost in opposite directions.”
Black swan event?
The biggest investment risk in the next 6-12 months is China's government policies, Doherty said.
“The potential for policy missteps as we have seen in the past 3-6 months are a huge risk. It could really turn international investors away from China and the region if they see these [missteps continuing].”
The other concern is the government’s will to support China's economic growth, which is linked to global growth, he said.
Due to nature of China’s closed economy and what they are trying to achieve, liberalizing the exchange rate, for example, “there are conflicting ambitions and eventually something may have to give.
“The next black swan event could be borne out of that.
“Our base case is that the three percent currency depreciation we saw will not happen again. A more gradual management of the currency will follow and that would be easier for everyone to digest.”
Doherty said despite the underweight, the bank is a believer in China's long-term story. Positive signs, specifically progress with China’s crackdown on corruption and laws to protect investment, would drive investment from foreign investors, Doherty said.
If the politicians have the will to persevere with the anti-corruption drive and politics don't prevent them from reaching their goals, China will be a huge opportunity in the future, he said.
"Politics are massively under-estimated in the investment community.”