Scientific Beta has thrown a roadblock in the path of further integration of China A-Shares into the emerging market index economy after saying their inclusion in its smart beta indices would "not be appropriate".

Instead, the company said it would be relying on a block of one hundred constituents made up of H shares (i.e. Hong-Kong-listed Chinese entities), P chips (Chinese companies listed in Hong Kong but incorporated in the Cayman Islands), Red chips (which will often be issued alongside A-Shares) and depositary receipts, which are modelled after American depositary receipts or ADRs.

The provider said there has been some progress made on the part of the Chinese authorities on the issues of tighter suspension rules and a doubling of the Qualified Foreign Institutional Investor (QFII) quota to $300bn.

However, for smart beta indices to work, it said, investors need to have access to solutions where liquidity risk is “thoroughly considered” because ultimately the weights of the stocks will not be equivalent to their cap-weighting but will depend on other weighting criteria.

In this light, it said that issues remain when it comes to A shares, including:

  • Chinese authorities could lock up foreign investor money in the case of extreme moves. Even with the recent liberalisation of QFII programmes, SAFE retains its power to exercise macro-prudential supervision over the repatriation of capital and may impose temporary restrictions.
  • Limited domestic availability of derivative instruments, in particular index futures, access to which is restricted to approved foreign institutional investors and remains limited in scope. This reduces investor ability to implement hedging strategies and risk management strategies.
  • Foreign-ownership restrictions on China A-Shares, set at 30%, could become critical with future inflows. Indeed, buy orders via stock trading links with Hong Kong will be halted if foreign holdings reach 28%, creating liquidity issues. Buying will resume only when the figure falls to 26%.

Scientific Beta pointed out the precautions taken by cap-weighted index providers, which are often adjustments to the capitalisation of the stocks in the indices, “are of little use in protecting the liquidity of non-cap-weighted indices.”

“As far as smart beta indices are concerned, this is why the rules applied to cap-weighted indices and their underlying universes are not appropriate and pose serious risks for investors.

It added that its alternative basket arrangement “preserves investors from these unnecessary investment risks.”

MSCI allowed in the first tranche of China A-Shares in the summer of last year having made the decision to include them the year previous. A report published by Dow Jones in February this year suggested the Chinese government may have put pressure on MSCI to include A shares in its emerging market indices. The report suggested that since the move, nine Chinese traded ETFs now track MSCI's indices compared to one previously.

A spokesperson for Scientific Beta said about it's own move "we do not know whether it is out of the blue but other providers’ moves have not necessarily been consistent or free of pressure".