China stocks: This may spark another round of buying

A woman holding balloons walks near Oriental Pearl Radio & TV Tower in Shanghai
Tomohiro Ohsumi | Bloomberg | Getty Images

China shares have surged this year, but with active fund managers still underexposed to the market, the rally isn't over, Goldman Sachs said.

"Funds of various mandates are underweight the market in a range of 140-600bp, and thus have marked benchmark stress and a need to raise exposure to China," Goldman said in a note Monday, citing EPFR data. "If emerging market funds alone increase allocations in the largest underweight sectors in China to marketweight, inflows could be worth $26 billion."

China shares have already rallied strongly, with Hong Kong's Hang Seng Index up around 21 percent year-to-date to its highest levels since early 2008, while the jumped around 39 percent over the same period to its highest since late 2007. Shanghai A-shares price-to-earnings ratio rose to -five-year high of 15.5 times, according to data from Nomura.

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But despite the rally making China shares more expensive, pressure for active funds to add more mainland exposure is likely to build as so far this year, those funds have underperformed their benchmarks for their worst performance since 2009, Goldman noted. Only 20 percent of emerging market funds and 40 percent of Asia ex-Japan funds have beaten their benchmark this year, compared with a 60-70 average over the past five years, it said, reiterating its overweight call on China shares.

"Underexposure has directly led to underperformance," Goldman said, noting that China is now the largest market in both the Asia ex-Japan and emerging market indexes, contributed about half of their year-to-date performance. Almost all Asian markets outside Hong Kong and China have underperformed the MSCI Asia Pacific ex-Japan index and within emerging markets, Russia, China and Hungary are the only three, out of 23, which have outperformed, it noted.

"The opportunity set for active managers has been almost completely limited to the HK/China space, which may intensify the pressure for them to close underweight positions," it said.

The China market is likely to get another boost as policy makers in Beijing have affirmed a desire to see A-shares included in MSCI global indexes and a willingness to make needed policy changes to adapt to MSCI's concerns, Goldman said. At the same time, efforts to connect the Hong Kong and Shenzhen stock exchanges and raise the Hong Kong-Shanghai tie-up quota will also help boost China shares, it said.

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Others also expect more gains. Despite Hong Kong shares' sharp rally, more funds are likely to flow out of the mainland and into the market, Credit Suisse said in a note Friday.

"More legitimate capital outflow is likely to be the trend in China," it said, noting that previously disguised illegal capital outflows will gradually be replaced by more formal ones as the mainland liberalizes its capital account.

In addition, with China's yuan now expected to depreciate rather than rise, the hurdle rate to make investing in overseas assets is declining, it noted.

There's another potential source of funds for the China market: its banks.

"Chinese banks, especially the smaller lenders, are forecast to report a boatload of stock market gains in their upcoming first-quarter earnings, judging from central bank data that revealed an unprecedented surge of equities investment by them so far this year," Reorient Research said in a note Sunday.

What's behind China's stellar market rally

Banking institutions put more than 8 trillion ($1.29 trillion) into stocks by end-March, compared with 6.5 trillion yuan in 2014, Reorient said.

"On average, banks have put 600 billion yuan or so into the stock market every month since December, forming a substantial buying force," Reorient noted.

In addition, "retail investors have also deposited a record amount of cash into their brokerage accounts during March," with weekly securities trading account openings doubling as some restrictions were removed, it noted.

—By CNBC.Com's Leslie Shaffer; Follow her on Twitter