Emerging market investors are facing huge upheaval as index providers prepare to add volatile Chinese A-shares to their emerging market indices.
Chinese stocks currently take up around a quarter of the emerging market indices from FTSE and MSCI, but swaths of its market have until recently been ineligible for inclusion.
But index providers are considering plans to incorporate mainland Chinese A-shares that have recently become available to foreign investors, as well as Chinese companies listed in the US, such as Alibaba, the ecommerce group.
FTSE announced last week it would start including A-shares and MSCI could follow suit when it announces its annual index review later this month.
When all Chinese stocks become eligible for inclusion the country will take up more than 50 per cent of the MSCI Emerging Markets index.
The doubling of China’s presence in the index will force an overhaul in passive emerging market funds and will lead to additional pressure on active fund managers to allocate money to China.
But emerging market managers said the index providers will make the change gradually, meaning it could take one or two years for all Chinese stocks to be included.
Gary Greenberg, manager of the Hermes Global Emerging Markets fund, drew a comparison to Japan’s dominance of EAFE (Europe, Australasia and the Far East) indices in the early 1990s when, following a huge rally in Japanese equities, it took up more than 60 per cent of the index.
Japan then proceeded to underperform most major markets for the next decade, leaving investors who followed the index languishing.
Mr Greenberg said if the A-share rally continued and overvalued China stocks ended up dominating emerging market indices, managers “will need to be brave and not own the highly valued stocks”.
“It requires conviction and may mean good investors underperform for a while if the benchmark is lopsided and expensive,” Mr Greenberg said.
Dale Nicholls, manager of the Fidelity China Special Situations fund, said the MSCI changes “could lead to investors with China in their benchmark having to make significant changes and also lead to passive funds buying A-shares”.
The change looks likely to happen in spite of a rally in Chinese A-shares stocks leading some experts to insist the market has become a bubble.
Since the opening of the Hong Kong Shanghai Connect scheme in November 2014, which opened up the A-share market to foreign investors, the mainland index has risen more than 90 per cent.
Ian Smith, portfolio manager for the Axa Framlington Emerging Markets fund, said he thought MSCI would wait until next year before including A-shares, in spite of last week’s announcement from FTSE.
He added that the adjustment would be “gradual and slow” because there were a number of problems to iron out with China A-shares, around issues such as settlement.
China’s advance changes the risk dynamics
It is not just the MSCI Emerging Markets index that will face upheaval from the opening up of the China equity market.
Hermes’ Gary Greenberg said when all Chinese stocks become eligible for inclusion in MSCI indices, the weighting towards China in the MSCI AC World index could be as much as 10 per cent.
This represents a significant shift from the current weight of 2.4 per cent and will mean emerging market equities will become a much bigger part of global indices, changing the risk dynamics for global investors.
