Should you invest in China’s domestic stock market?

by , 13th June 2018

China has just taken another step in opening up its markets to investors. At the start of this month, MSCI, one of the world’s most influential index providers, added roughly 200 Chinese A-shares to the MSCI Emerging Markets (EM) index, a benchmark for fund managers all over the world. While investors have long been able to invest in Chinese stocks, this is the first time that A-shares – which are listed in Chinese yuan on the Shanghai or Shenzhen (the more tech-heavy market) stock exchanges – have been included in the MSCI index. The index provider finally approved their inclusion in June last year, after China made it easier for foreign investors to buy and sell the stocks, via the Hong Kong Stock Connect.

It’s a small step for the time being – the China A-shares component will account for just 0.73% at first (although Chinese stocks listed in Hong Kong or elsewhere already account for about 30% of the MSCI EM index). But if China does end up being included fully in the longer run – which seems likely – then, reports Reuters, Chinese stocks could end up accounting for around 45% of the EM index, with about 16% of that comprising A-shares.

China, clearly, represents a huge opportunity for investors. It is on course to be the biggest economy in the world (on some measures it already is), and it has the world’s second-largest equity market. Many of these are interesting companies, with exposure to a fast-growing domestic market that only seems likely to grow further – highlights include Kweichow Moutai, one of the world’s most valuable alcoholic drinks companies.

China of course, faces a lot of challenges at a “big picture” level too. China and the US are locked in the early stages of a trade spat, which may or may not get worse. On the domestic front, the Chinese economy faces plenty of challenges too, not least of which is heavy levels of debt and a desire to become more open economically without giving up much, if any, political control. It is always tricky to invest in an economy which is run by an authoritarian government. You never know quite how reliable your property rights are when push comes to shove.

However, these issues and opportunities are well-known to investors, who have long had access to China. The bigger questions are those that are more specific to the A-shares. The simple fact is that this is a highly-risky market, even by EM standards – imagine a much, much sketchier version of London’s AIM market, and you are barely even getting close. Governance is poor, at best. Even just looking at the stocks that made it onto MSCI’s list for initial inclusion – a mere fraction of the 3,000-odd A-shares in existence – more than a third score the lowest possible ESG (environmental, social and corporate governance) rating. Meanwhile, according to the Financial Times, more than two-thirds of A-shares have a major shareholder who owns more than 25% of the company’s stock, so minority shareholders are not high on the pecking order. Dilution (where more shares are issued, diluting the value of existing holdings) is rife.

The companies are, on average, heavily indebted, and nor is it a particularly cheap market. The A-shares also come with another unappealing “quirk” – the companies are allowed to suspend trading of their shares for months at a time, effectively locking shareholders in at periods of extreme stress. This happened en masse just a few years ago, during the 2015 stock market turbulence, where more than half of the companies on the A-share market stopped trading in their shares. MSCI has said that companies whose shares have been suspended for 50 days or more will be excluded from the index, but clearly that’s not a hugely effective safeguard if you happen to be invested in one of those companies.

On the flipside, assuming that China continues to open up its financial markets, and that MSCI continues to increase the proportion of A-shares in its EM indices (which is a long-term project), then it’s fair to say that a lot of money will be heading into these stocks over time. So let’s assume that you aren’t too worried about the ups and downs of trade spats,  governance mishaps, and the whole question of navigating global financial market cycles along the way. You just fancy investing in China for the long run. What are your options in the ETF world?

While the focus might be on A-shares just now, you don’t have to stick to A-shares by any means. One interesting option is the ICBC Credit Suisse WisdomTree S&P China 500 ETF (CHIP), which tracks the S&P China 500 Index. This gives exposure to “500 of the largest and most-liquid Chinese companies” and covers all Chinese share classes, including overseas-listed stocks as well as A-shares (about a third of the index is in Hong Kong, and a third in Shanghai). So you get exposure to the big tech giants – Tencent and Alibaba – as well as the likes of Kweichow.

Alternatively, if you are looking for more tightly-focused domestic exposure, the Xtrackers Harvest FTSE China A-H 50 ETF (AH50) is another option. This one aims to track the performance of the 50 largest companies traded on the Shanghai or Shenzhen exchanges, and owns either the A-share (the mainland China listing) or the H-share (the Hong Kong listing).