It’s more than two months since MSCI announced its intention next summer to add China A-shares in some of its indices, including its flagship emerging markets Index.
So how is the investment industry responding? Reluctantly, it would seem.
AsianInvestor spoke to over a dozen market participants, including asset owners, investment consultants, asset managers and index providers, to gauge what has changed. Almost all were reluctant to raise their exposures but thought they had no choice but to become more familiar with China’s mainland shares.
The initial weighting in the widely tracked MSCI Emerging Markets Index is largely symbolic, comprising just 0.73% of the total. But it will still have a big impact. In effect, from June 2018 asset managers will have to allocate at least 0.73% of their funds benchmarked against the index to onshore China equities just to maintain a neutral position on the market.
“China investment has become a conscious decision equity investors have to make … if they use the index as a benchmark for performance,” Janet Li, director of investment for greater China at Willis Towers Watson, told AsianInvestor.
For many active fund managers, that’s not as easy as it first appears.
“For every investor who is there [investing in Chinese A-shares], I can find you 10 who aren’t,” said Natalie Shaw, head of cash equity distribution for Asia Pacific at BNP Paribas Global Markets, adding that education is therefore needed.
Concerns include China’s capital controls, its mounting debt burden, stock underperformance and insufficient corporate governance, as well as operational issues such as the complexity of various access channels.
These are rational fears. Yet the pressure to invest more will only rise as China’s A-share weighting in the MSCI’s indexes does, potentially to a full emerging markets index weighting of around 20%. “It’s the goal to have a full inclusion of A-shares into the EM index eventually,” Chia Chin-Ping, MSCI’s Asia-Pacific research head, told AsianInvestor.
According to MSCI, $300 billion in fund assets under management (AUM) track its Asia index; another $1.6 trillion is benchmarked against its Emerging Markets index; and $2.9 trillion follows its global index. The China A-share allocation has been added into all three.
Goldman Sachs estimates the A-share addition could usher in $12 billion of net A-share buying from passive emerging market funds that follow MSCI’s emerging markets index.
While passive funds have little choice but to buy, active investors are so far proving more cautious. Aaron Costello, Beijing-based managing director on Cambridge Associates’ global investment research team, said there had been a lot of discussion about whether investors should ramp up China A-share exposure, on the expectation of rising share prices following the MSCI inclusion.
“We’ve been advising clients not to do that, because to rush in on the expectation that other people rush in is a momentum trade, not long-term fundamental investing,” Costello told AsianInvestor. Cambridge Associates advises asset owners and private family clients.
Costello’s view is shared by Mark Konyn, chief investment officer of Hong Kong-based life insurer AIA. He noted MSCI’s A-share inclusion was in part a reward for China’s commitment to continued financial sector reforms. But in itself the inclusion “won’t have an immediate impact on how we think about our China investment approach,” he told AsianInvestor.
Similarly, MSCI is “not in a rush for future inclusion [of a greater A-share weighting],” MSCI's Chia said. “We will see how the market evolves from here. It’s very important that investors have a very good experience, particularly with the initial inclusion.”
Other asset owners take a similarly relaxed view of China, telling AsianInvestor that their overall China exposure is not that large and that they don’t plan to increase it any time soon.
Paul Carrett, CIO of Hong Kong-based insurer FWD, with $17 billion in AUM, feels there are reasons to be cautious. He cited the mounting debt mountain in China’s financial system as a reason for remaining cautious on the country. Its total outstanding credit stood at 260% of GDP last year, up from 160% in 2008, according to Bloomberg Intelligence.
China’s capital controls also continue to constrain greater investment into the country.
Alvin Fan, chief executive of OP Investment Management, was meeting family offices and institutional investors in the US when he spoke to AsianInvestor. He noted the biggest concern among these investors was doubt over the certainty of repatriating investments and positions from China, as well as the relatively untested nature of the Stock Connect programme, a mutual equity market access scheme between Hong Kong and the mainland.
Indeed, several interviewees admitted to being confused by the multiple ways of accessing China’s stock markets. Investors can use the Stock Connect, or invest via the qualified foreign institutional investor (QFII) scheme, or through a renminbi-QFII programme.
“If institutional investors need to spend much time in understanding the process [of accessing Chinese equities] it will delay their decision on whether to make the investment,” Willis Towers Watson’s Li said.
Added to that is sheer market risk versus return. Investors noted the general underperformance of A-shares (the Shanghai Composite Index edged up only 9% this year as of September 6, while the Hang Seng Index surged 25% over the same period).
Also, China’s corporate governance standards are often found wanting. Ken Wong, Hong Kong-based client portfolio manager for Hong Kong and China at Eastspring Investments, told AsianInvestor many global investors disliked the fact some state-owned enterprises refused to distribute cash flows to shareholders, claiming national duty superseded shareholder rights.
Despite the concerns, it’s worth remembering that reforms are continuing to happen. The introduction and liberalisation of Stock Connect is one example, as is the relaxation of pre-approval rules for financial products and a reduction in the number of stock suspensions.
Improvements in these three key factors helped convince MSCI to make A-shares eligible for index inclusion this year, Chia said.
The market itself is gradually improving too. While some state-owned enterprises do withhold dividend payments, the dividend yield of the companies comprising the local CSI 300 index, which tracks the 300 most liquid A-shares, stood at 2.1% — not too far below the 2.4% global average. That suggests Chinese companies are improving their cash earnings payouts, even to minority shareholders, said Thomas Deng, greater China CIO at UBS Wealth Management.
For many investors, the key to improved engagement will come down to education. Fan noted that most American investors don’t possess enough knowledge about market basics in China and are discomforted by the fact they won’t enjoy the same control of their investments as in the US.
But that also offers an opportunity. “The various hurdles to invest in the market makes the China investment rewarding for institutions that are willing to spend time to study the market,” argued Li. “The market does have the potential for growth and good investment returns.”
China’s A-share equities are set to become a bigger part of the global equities firmament. For all their reservations, it’s in the best interests of global investors to better understand it.
The story is based on and updated from a feature on China equities published on the August/September issue of magazine. In the second part of the series, we’ll discuss how investors see the different ways to access Chinese equities, including passive vs active, internal vs mandates, and Chinese vs foreign managers.