No sooner have seen the wider embrace of China A-Shares by emerging market index providers taken place than worries are being expressed about concentration risk.
Just this week, MSCI raised the already signalled inclusion factor for large-cap China A-Shares in its Emerging Market index from 10% to 15% with another step up to 20% set for November.
They are following in the wake of FTSE Russell which in June similarly began adding China A-Shares to its FTSE Emerging Markets Index while S&P is thought to be planning to add them to its own index in September.
Mandy Chan, head of Chinese and Hong Kong equities at HSBC Global Asset Management, said the move by MSCI “provided a major uplift for China” as it seeks to open up its equity markets to greater foreign investment.
She added that the increased inclusion levels could bring in upwards of $20 billion from global investors tracking the MSCI benchmarks.
“The weighting increase is modest in its own right, but it will continue to prompt foreign investors to increase their investment in the world’s second largest equity market,” she added.
However, the ratcheting up of A-Shares inclusion in the leading emerging market indices is already causing some concern about the degree to which China will represent a concentration risk.
Such is the view of Steven Schoenfeld, founder and CIO of BlueStar Indexes, who suggests there has been precious little debate regarding the issue despite the moves coming at a time of greater geopolitical tension between China and the US.
Although the major EM indices have a history of single countries dominating the weightings of EM benchmarks, this is normally spread between three-to-five countries.
Calling the growing weight of China with the emerging market indices of the three main providers as “unprecedented”, Schoenfeld suggests both investors and fiduciaries should be “aware of this increased country concentration risk.”
Can’t stop the flow
However, while EM index inclusion is one reason for the flow of money into Chinese equities, there are structural changes and market reforms taking place which both explain some of the flow of money and also provide some reassurance for investors worried about single-country risk.
“The weighting increase is modest in its own right, but it will continue to prompt foreign investors to increase their investment in the world’s second largest equity market,” says Chan “Increased foreign ownership will help to improve the A-share market infrastructure and encourage listed companies to align their disclosure, transparency and governance standards to global peers.”
Against this backdrop it should not be surprising that the index providers have laid out a clear path for greater inclusion. As Schoenfeld admits, these moves – and announcements regarding Saudi Arabia and Argentina – have been well signalled.
“For the 2019 MSCI changes, MSCI laid out a clear path for inclusion of the Chinese A-Shares as well as Saudi Arabia and Argentina, and FTSE did the same with their inclusion of Saudi Arabia (in five tranches) and China A Shares (in at least three tranches, with the second tranche scheduled for next month),” he says.
And trade wars aside, there are some very strong macroeconomic reasons behind the moves as far as China goes. As Chan points out, while growth and valuation predictions have been trimmed in recent months, valuations for onshore and offshore equities “remain undemanding.”
Chan also says that the timeline for further inclusion from here will still be a multi-year process bearing in mind that previous instances of greater inclusion have taken six or seven years.
"Incremental reforms such as alignment of settlement cycles and access to hedging and derivatives could go a long way towards potentially shortening that timeline," she adds.
“While overseas investors will need to use existing cross-border channels for the foreseeable future, the country has already made big strides in opening up its equity markets, and we do not expect the direction of travel to change.”