The decision by MSCI to include an element of Chinese A-shares in its benchmark Emerging Market and ACW indices marks a defining moment for investors but still leaves Chinese equities underrepresented in the indices.
The inclusion of only 222 large cap A-shares out of a universe of over 3,600 represents on a pro-forma basis approximately 0.75% of the weightings of the MSCI Emerging Market index. The shares will be included in a two-stage process in June and August.
Eng Teck Tan, senior portfolio manager for Asian equities at Nikko Asset Management, said the “expected but long overdue” move by MSCI had come after four years of intense negotiations. MSCI said the move had the broad support of institutional investors with which it had consulted which included asset owners, asset managers, broker/dealers and other market participants.
The move represents a first step towards the greater inclusion of A-shares within its indices, said Remy Briand, MSCI managing director and chairman of the MSCI Index Policy Committee. He added that its indices would “reflect a higher (A-shares) representation” when there was further evidence of an alignment with international market accessibility standards, proven sustained accessibility within Stock Connect and as the international institutional investor base gained further experience in the market.
“MSCI is very hopeful that the momentum of positive change witnessed in China over the past years will continue to accelerate,” Brand added.
Taken together the Shanghai and Shenzhen markets represent the second-biggest stock market in the world after New York.
Tan from Nikko Asset Management said the historical precedence for full inclusion was 10 years. “Taiwan and South Korea are the most recent showcases of the time it takes for full inclusion in MSCI indices,” he said. “In the 1990s, it took Taiwan and Korea almost nine years to be fully included. At one point, Taiwan and Korea accounted for more than 40% of the MSCI Global Emerging Markets Indices.”
He added that China was larger and “arguably more complicated” however the rapid advancements likely in technology and information flow – along with evident political will – would mean that full inclusion would likely happen at some stage.
MSCI credited was the expansion of China’s official Stock Connect programme which enables investors in the Shanghai and Shenzhen stock exchanges to trade share listed in Hong Kong for its move. This alleviated concerns over repatriation limits suggested James Butterfill, head of research and investment strategy at ETF Securities, and means offshore investors can now buy China A-shares in both mainland Chinse stock markets.
“This has boosted access to certain domestic stocks for offshore investors whilst the RQFII (renminbi qualified foreign institutional investor) quota programme continues to operate to allow for investment in a wider pool of China A-shares,” he added.
Alongside the limited influx of shares, a 5% partial inclusion factor will also be imposed. “If given full factor inclusion, China’s weighting, including offshore Hong Kong-listed shares, could potentially quadruple to an estimated 8%,” said Tan. “Even in that scenario, China will still remain the most under-represented country in the index, compared to its economic significance.”
Benefits of broader indices
Writing ahead of the confirmation of the A-shares move from MSCI, Nizam Hamid, ETF strategist at Wisdom Tree, said the limited nature of the A-shares to be included in the indices highlighted the benefits of existing index strategies such as the S&P China 500 which features a much broader coverage of all Chinese shares classes.
“One aspect of the sector weights within the S&P China 500 index is that it more closely measures the Chinese economy, especially as it encompasses the structural shift with a greater focus on consumer spending and technology as opposed to older state-owned enterprises and financials,” he said.
The weighting for consumer-oriented sectors in the MSCI China index will rise to circa 15% once the A-shares are included compared with a 23.4% exposure for the S&P China 500. By contrast, the MSCI China index is more heavily biased towards the financials and real estate with a weighting of close on 30% compared with just over 26% for the S&P China 500.
“Overall investors looking to access broad China equities, without waiting for a gradual and piecemeal approach by MSCI, may look consider the S&P China 500 index that already offers a complete solution,” said Hamid.
Nevertheless, the news of the inclusion of the A-shares was viewed as net positive for potential passive investment inflows into China. Stephen Tu, a senior analyst at ratings agency Moody’s Investor Service said the move meant MSCI will be better able to satisfy investor demand for broad-based index exposure to China’s economy and also enable investors to build additional strategies using the domestic Chinese market. “This should lead to increased client demand and diversification benefits for investors,” he added.
Butterfill at ETF Securities said he believed the A-shares price-to-earnings ratio relative to H-shares show that A-shares is “currently fairly valued.”
“With the size of the inclusion still representing a small proportion of the overall size of the Chinese market capitalisation, we believe a solid recovery of Chinese manufacturing PMI based on a credible reform agenda will provide stronger support for A-shares over the longer run.”