Overseas investors have been slow to move into Chinese A-shares, despite MSCI's decision to include the mainland markets in its indices from next year.

But, despite concerns such as China's capital controls, its mounting debt burden, stock underperformance and corporate governance issues, international investors have little choice but to at least consider what is now the second biggest combined stock market in the world. It simply can't be ignored.

There is little doubt China’s A-shares are likely to weigh heavier in the MSCI EM index over time. MSCI will come under pressure to raise the weighting as Beijing continues liberalising its economy. 

Investors need to prepare for that change. And doing so will require them to decide whether to do so actively or passively, and if the former whether they should do so internally or though outside managers. The answer will differ, depending upon the priorities of the investor in question.

So far, most foreign investors think an active investment approach makes most sense.

Anna Tong, Asia-Pacific head of investments at Invesco, which offers active funds and ETFs, told AsianInvestor many stocks in major indexes don’t represent the fastest growing sectors of the economy. Added to that, there is a wide dispersion in fundamentals across companies, even in similar sectors.

AIA also takes an active investment approach. “We believe we can add value through active management and work with well-defined risk budgets that are specified as part of our strategic asset allocation process,” said CIO Mark Konyn. “The experience in China has been good so far.”

That said, he predicts passive strategies will play a bigger role in the future as more institutional investors put money into China. But to do so, they will need to be cheaper. While US and global exchange-traded funds typically charge an annual fee of five to 50 basis points (bp), A-share ETFs cost 70 to 100bp, said Aaron Costello, Beijing-based managing director on Cambridge Associates’ global investment research team. The cost needs to fall if more passive investments are to be encouraged.

It will also require more mainland Chinese institutional investors. China’s stock market remains very retail investor-dominated, despite the introduction of QFII and Stock Connect.

“I hope over time we will see more responsible investing from insurance companies and we’ll see the development of independent institutions, potentially pension funds, endowments etcetera,” said Konyn. “That would promote a more efficient market that is less dominated by short term speculation.” 

China’s flagship pension fund, the $294 billion National Council for Social Security Fund (NCSSF),  argued in a June report that passive investment strategies – and particularly smart-beta exchange-traded funds – will enter mainstream usage for mainland stocks, as market efficiency improves. 

The NCSSF argued that index-based factor investing would be a major trend among asset owners with lower risk appetites, such as pension funds.

Internal vs. external

Those investors who do decide on the active route must then contemplate whether do so in-house or through an external manager.

Investors who are already familiar with investing into China are likely to prefer in-house investing. AIA, for example, manages its China investments mostly in-house. “From the early inception of our China business we have sought to manage assets in-house, recognising the likely scale of our operations and the potential growth of the portfolio,” Konyn said.

For institutional investors lacking experience in buying into China, caution is advised. Janet Li, director of investment for greater China at Willis Towers Watson, notes the country’s financial market is quite regulation-oriented, so asset owners unfamiliar with the market would be wise to team up with fund managers or consultants that know it well.

That doesn’t necessarily mean allying with a local investment company. Costello said most investors he spoke to chose foreign-backed managers, in large part because there are few institutional-quality local fund managers.

Added to that, most global fund managers employ Chinese-speaking investment teams based in China and Hong Kong. The key difference between domestic and foreign managers is the institutional framework and standards foreign asset managers can provide, Costello said.

WTW’s Li has a different perspective, arguing that many international investors have teamed up with local fund managers. But she noted that local fund houses rely more heavily on star fund managers than institutional strength, leaving their investment capabilities vulnerable to staff turnover.

“Hopefully this issue will be resolved with the development of the asset management industry,” Li said. 

To provide the latest insights on Asia's ETF scene, AsianInvestor is co-hosting Inside ETFs Asia, the leading global ETF event, at the Grand Hyatt in Hong Kong on November 8-9. For further details, visit the website or contact Terry Rayner via email or on +852 3175 1963.