Index provider MSCI will announce the results of its Annual Market Classification Review later today (June 14) and it could decide to include Chinese A-shares in its Emerging Markets Index for the first time.
Chinese A-shares, which are aimed at the domestic market, have had a turbulent time since the start of the year after the initial euphoria of the Hong Kong-Shanghai Connect coming to the fore.
When the A-shares were rejected from the index review last year, the Chinese market suffered from its worst trading day in nine years. This triggered the use of so-called ‘circuit breakers’ designed to suspend trading after significant market movements.
Against the backdrop of the forthcoming review, Citywire Selector canvassed leading managers what the announcement could mean for emerging markets.
The time will come
Citywire + rated Jian Shi Cortesi, who runs the Julius Baer EF China Evolution fund, thinks China A-shares will eventually be included in the index, even if they are not included in today’s announcement.
Previously MSCI raised a few issues and recently the Chinese authorities have introduced some new rules that are addressing some of those issues, like A-share stocks being suspended, so that increases the chances of A-shares being included.
I think the initial inclusion will be very low, so the key thing to watch is the inclusion factor. When Korea was included back in the early 90s, the beginning inclusion factor was 20%. That is market-cap weighted but it was only about 20%. Gradually that percentage increased over time to include 100% inclusion.
Given the size of the Chinese A-shares market and also some of the liquidity concerns related to the availability of A-shares to international investors, I think the inclusion factor could be much lower than 20%. It could potentially be 5 or 10%. In that case it would translate to maybe only 1 or 2% of MSCI Emerging Market Index being in Chinese A-shares.
Currently I am not planning to make any changes, as the China fund focuses on themes driven by the Chinese consumers and currently we already have 10% exposure to Chinese A-shares, mainly Chinese consumer stocks and healthcare stocks.
We are happy with the holdings we have and we will not increase the weighting just because of the MSCI announcement. As time goes one we will probably include more and more Chinese A-shares.
Many Chinese A-share stocks actually trade at higher valuation than stocks listed in Hong Kong or listed in the US. So for that reason we still find many opportunities outside the A-share market.
Won't have a major impact
Citywire + rated Sammy Suzuki, who runs several emerging market funds at AllianceBernstein, thinks the inclusion of China A-shares into the index will not affect his holdings in China.
We are pretty benchmark insensitive and the emerging markets index is inefficient, as it’s also very volatile. I think of all the different asset classes it’s the one where we shouldn’t focus on the benchmark. Which is why, if you look at our exposure to China today, it’s something like 10% less than the benchmark.
Therefore I don’t believe that an index change will materially influence our position in China, I think it will be driven more by the specific opportunities available to us.
Too soon to add
The head of global emerging markets equity at Mirabaud Asset Management, Daniel Tubbs, thinks it is too early for China A-shares to be included in the index and would not make any changes to his funds.
If they do make the announcement tonight it will be quite symbolic because China craves the recognition that would be commensurate with the world's second biggest economy. But the actual impact in the short term would be relatively muted because the A-shares wouldn't physically enter the index for another year or so.
We are already overweight to China, but through H-shares, which are trading at roughly half the multiple of A-shares, so we believe we already have the exposure to China that we want through a much cheaper means of investment.
We are much more interested and excited about any potential comment from MSCI with regards to Saudi Arabia. Although we don't expect Saudi Arabia to be included in the MSCI EM Index this time around, we do anticipate that Saudi will ultimately be included.
It will be a much bigger proportion of the GEM index. We believe once oil company Armco is listed and once Saudi is included in the emerging market index, the total Saudi Market could be anywhere towards 9% of the GEM index, therefore much more meaningful that China's partial inclusion of just 1.1%.
Greater China could dominate
Citywire AA-rated Mike Shiao, who runs the Invesco Greater China Equity fund with Lorrain Kuo, thinks A-shares will eventually be added to the MSCI EM index and would indicate the country is liberalising its financial accounts.
The key prerequisite for China A-share inclusion to occur in the future is satisfactory resolution of the ‘market accessibility’ issue for global investors. This boils down to the fact that China’s capital account is not yet fully open.
Restrictions remain on remittance and investment amounts in China’s domestic stock markets, primarily via the Qualified Foreign Institutional Investor (QFII) and Renminbi Qualified Foreign Institutional Investor (RQFII) schemes, which are only open to global institutional investors.
The inclusion of China A-shares will also transform the way investors obtain their emerging markets exposure. Under a pro-forma full inclusion scenario, Greater China markets would represent around 51% of the EM index.
If we further include commodity-driven economies like Brazil and Russia, which are highly influenced by Chinese demand, the remainder of the EM index breakdown is very fragmented across various countries, leading to less need for investors’ attention.
Therefore, making the right investment call about China is likely to be critical when it comes to successful EM investing. It could also lead to an increase in more dedicated Chinese equity mandates. In our view, more global investors will decide to invest directly in dedicated Chinese equities (and potentially select EM markets), instead of EM equities as a whole, given China’s sizeable influence in the EM.
Not the best time to tap
Xiaoyu Liu, who co-manages the Aviva Investors Asian Equity Income fund with Ed Wiltshire, thinks the Chinese government is taking measures to improve quota allocations and make A-shares more accessible.
We believe that inclusion is inevitable, but now may not be the best time as accessibility remains a problem for investors. After inclusion, China will become an even bigger part of the MSCI Emerging Market Index.
Overseas-listed Chinese companies currently comprise 26.6% of the index. Including A-share companies, listed on the Shanghai- and Shenzhen-exchanges, at a 5% weight would take that to 28.2%, and to 40.6% for full inclusion.
Partial inclusion has very little impact on active fund managers because we are not bound by the index; in our fund, we already own A-share securities. These are high quality companies listed only as A-shares which we like regardless of inclusion. The inclusion process is positive for emerging market investors as it increases choice.
The head of emerging market equities at Robeco, Wim-Hein Pals, thinks the A-shares inclusion would be positive and support the small overweight to Chinese equities in his Robeco Emerging Markets Equities fund.
In the short term an inclusion of A-shares would imply a positive boost to sentiment towards the Chinese financial markets in general. In a way it is evidence that reforms and further liberalisation of the markets are being rewarded.
Also, from a fund flow perspective it means more investment flow going to Chinese equities, both local shares and the Chinese shares listed in Hong Kong and New York. This goes for both active investment funds and passive money flows; index trackers have to invest almost 30% of the EM dedicated money to Chinese stocks.
Finally, it is supportive to the renminbi, since more investment demand for the Chinese currency is positive. Longer term though, worries remain on the sustainability of the increasing debt burden and the sluggish growth perspectives of the Chinese economy. At current valuation levels of ten times this year’s earnings most Chinese equities are priced for these challenges.