What MSCI adding China A-Shares means for investors

From 2018, the inclusion of the mainland China companies in the emerging market index means retail and institutional investors across the world will be given greater access to companies whose shares have traditionally been available to domestic, but not to international, investors.

The move, which constitutes just 0.73 per cent of the MSCI Emerging Markets index, is also expected to bring a further $17bn (£13.2bn) to $18bn (£13.9bn) of investment money flowing into China’s domestic stock market.

Positive step?

Gary Monaghan, an investment director based in Hong Kong for Fidelity International, says: “A-share inclusion in MSCI indices is a positive step for China’s equity markets and its overall capital markets.

“This also benefits investors as they now have broader access to companies, and more ideas means more potential investment opportunities.

We believe foreign investors would be more interested in quality names in sectors that enjoy secular growth opportunities. Howard Wang

"The inclusion of A-shares is limited, as expected, but there is certainly a case for greater inclusion over time, which will only strengthen investor focus on China.”

Top five companies added by market cap (as at 22 June 2017):

• ICBC $255.9bn (£198.8bn).
• China Construction Bank $207.7bn (£160.8bn).
• Petrochina $195.2bn (£151.6bn).
• Agricultural Bank of China $162.3bn (£125.8bn).
• Bank of China $152.8bn (£118.1bn).

According to Josh Crabb, head of Asian equities for Old Mutual Global Investors, the inclusion of the domestic A shares in the index is “an historic milestone along China’s path to open up its domestic financial markets and attract foreign capital inflows”, the importance of which should not be underestimated.

He explains: “The anomaly that exists between China’s economic strength and stock market capitalisation, relative to its index weight, is finally starting to correct.”

Another manager who has welcomed the move is Howard Wang, manager of the £184m JPMorgan Chinese Investment Trust, whose portfolio already has a 16.9 per cent exposure to the China A-share market.

He comments: “This is an acknowledgment of the tremendous effort China made in the past few years and it is a key milestone in the overall capital market liberalisation process.

“We expect this to provide a much-needed catalyst for the lagging China A-share market year-to-date.”

The liberalisation process has been going on for a while. There was the Shanghai-Hong Kong programme in 2014 and the launch of the Shenzhen-Hong Kong programme in 2016, which according to Victoria Mio, chief investment officer for China at Robeco, has "greatly improved the capital accessibility of the foreign capital".

She explains: "These allowed investors to trade shares easily on the other markets using their local brokers and clearing houses.

"The trend of China's opening up of its capital market is set to continue, as China is also planning to launch a bond market connect between Hong Kong and the mainland exchanges."

Unwarranted

But not everyone believes this marks a significant sea-change in Chinese open-door policy. Nimalan Govender, portfolio manager, Asia Pacific, for Morningstar, comments: "There was always a question of whether the hype surrounding the A-shares addition was warranted.

"The reality is the inclusion weight is very small and is unlikely to materially impact the underlying fundamentals.

"Indeed, Morningstar's own index group has so far decided against adding China A-shares to the Morningstar Emerging Markets index, citing the lack of any revision or clarification from authorities on the issue of ownership limits."

That said, Mr Govender added: "China's strong commitment to reform, and the brisk pace of implementing new measures, keeps this under review."

And, from a portfolio point of view, he agrees that the addition potentially allows for better diversification of a portfolio's performance drivers, which could create a better link to the "long-run growth drivers of the Chinese economy and access to companies that operate in industries which pass under the radar of government".

Overseas interest

Ms Mio also believes removing the restrictions of the past will increase foreign ownership of mainland shares. She comments: "Due to the restricted channels to access the domestic A-share market in the past, foreign investors only account for 1.3 per cent of the shareholdings in the China A-share market. 

"Foreign investors' participation in the stock market in China is much lower than their peers, such as 31 per cent in Japan and 13 per cent in the US."

However, there is not more demand, and more channels by which investors can access such shares.

Performance may also start to pick up, which might help generate more overseas interest.

So far, according to data from MSCI, the mainland Chinese stock market has indeed been lagging, compared with the MSCI All Country World index (ACWI) and even the MSCI Emerging Market index.

In 2016, China’s A-Shares market was down 18.97 per cent at year end, compared with the MSCI ACWI, which was up 8.96 per cent and MSCI Emerging Market, which was up 11.60 per cent, partly as a result of a strong Indian stock market.

Graph: A Shares v MSCI since 2003

However, in recent months, China’s recovery has been notable; the MSCI China index was up 4.89 per cent compared with a 4.42 per cent rise in the MSCI ACWI and a 6.38 per cent rise in the MSCI EM index over the second quarter of 2017.

In June, the MSCI China posted its strongest return this year, rising 6.49 per cent in June, compared with just 0.63 per cent for the MSCI ACWI and 1.07 per cent for the MSCI Emerging Markets index.

And according to investment adviser Tilney Bestinvest's latest Spot the Dog report, funds avoiding a high exposure to China recently have suffered.

The report says: "There were big differences in returns between key Asian markets, with China and South Korea leading the way, so funds cautiously positioned towards these markets, in favour of the likes of India or Australia, have lagged.

"The opening up of big disparities in performance between markets in the region has led to a period of increased divergence between funds investing in Asia."

Who will buy?

Any investors with a passive fund tracking the MSCI Emerging Market Index will now be obliged to buy the A shares when the rebalancing takes place in May 2018. Those who are holding exchange-traded funds or index funds will therefore become investors in the ‘new 222’.

The move will also affect active investors – those either buying shares individually, whether institutional or retail investors – or individuals who are investing in actively managed portfolios.

The trend of China's opening up of its capital market is set to continue, as China is also planning to launch a bond market connect between Hong Kong and the mainland exchanges. Victoria Mio

However this poses some questions as to whether investors – whether passive or active – will want additional exposure to China, and what to do with it when they get it.

Mr Crabb comments: “While the process will be more gradual for active investors, they too will have to consider realigning portfolios.”

What next?

According to Mr Wang, the move by MSCI may encourage other index providers to follow suit, adding more A-shares to global or emerging market indices.

Mr Wang explains: “Over the medium to longer term, we expect the weighting of China A-shares to expand over time in global indices.

“The higher foreign participation should help rebalance the investment styles and horizon of the market which is mostly dominated by retail investors at the moment.

“In addition, we believe foreign investors would be more interested in quality names in sectors that enjoy secular growth opportunities.”

The subsequent improvements in market liquidity will also encourage more investors to the market, as Mr Crabb comments: “There are both short and long-term consequences of this move.

“In the short term, the decision will act as a positive catalyst in terms of liquidity and, by implication, performance for China’s domestic shares.

“Over the medium to long term, it should reduce market fluctuations by increasing the participation by foreign institutional investors."

simoney.kyriakou@ft.com