On May 15, index provider MSCI announced the first China A-share constituents of its emerging market benchmarks. The widely anticipated move brings the benchmark provider one step closer to officially adding A-shares to the MSCI China index and the MSCI Emerging Markets index on June 1.
Over the next decade, $400 billion is expected to flow into A-shares as a result of the inclusion, as AsianInvestor reported recently. Nevertheless, this is considered by many as just the tip of the China investing wave.
In a two-step process, the ‘foreign inclusion factor’ (FIF) – the proportion of the MSCI EM index that mainland equities will account for – will be raised to 5%. The expectation is that the FIF will be raised even higher over time.
But how quickly will the FIF increase? And what measures will China need to undertake to improve its chances of raising the FIF?
We asked a strategist, a portfolio manager and two securities services specialists for their views on these issues as well as on whether China is over- or under-represented in the MSCI indices.
The following transcripts have been edited for clarity and brevity.
Ross Teverson, head of strategy for emerging markets
Jupiter Asset Management
China is already well represented in the MSCI Emerging Markets Index. Chinese representation increased in 2015 with the inclusion of US-listed Chinese tech companies, including Alibaba and Baidu. Today, China is already the single largest country in the index with a weighting of around 30% - twice the size of the second-largest index constituent, South Korea.
When A-shares are added to the index next month, an inclusion factor of just 5% will be applied, limiting their weighting in the index to less than 1%. However, over time, with a higher inclusion factor, total Chinese representation in the index could eventually rise to above 40%. This would be a high level of country concentration, and therefore single country risk, for an asset class that comprises over 20 different countries.
Foreign investor ownership of A-shares remains very low at around 2% (which compares to a figure of 30% or more for some other Asian markets) and, for many foreign investors, the fact that the A-shares of Chinese companies typically trade at a premium to Hong Kong-listed stocks reduces the urgency to invest.
However, a gradual increase in the inclusion factor for A-shares will lead to greater interest in the asset class and it appears that many of the elements required for a higher inclusion factor are already in place or in progress.
These include improved market access through Stock Connect and the raising of investment quotas. The relative ease and frequency of share suspensions in the A-share market does remain a concern for foreign investors and if the number of share suspensions declines due to tightening of stock market rules, that would also be taken positively.
Andrew Mattock, China portfolio manager
While upcoming additions of China A-shares to MSCI’s indices are an important step forward, we believe China continues to be under-represented by all major benchmark providers, including S&P and MSCI. China’s weight in MSCI’s regional indexes could grow even larger if MSCI eventually decides to include mid-cap A-shares and any large-cap A-shares with greater than 30% foreign ownership, both of which are currently excluded.
We believe fuller inclusion of China’s A-shares into global indices will likely reshape those indices in the foreseeable future. Over the next five to 10 years, for example, China could account for more than 50% of the MSCI Emerging Markets Index. By that point, we expect that the index would either need to be renamed for its largest constituent (China), or be reconstituted so that China is spun off.
This means China would effectively become its own asset class, similar to Japan—a change that would likely be reflected in institutional asset allocation models as well. For investors with time horizons of five to 10 years or longer, increasing allocations to China now, particularly to dedicated China equity strategies, can help them shift portfolios toward what commonly used benchmarks may look like in the future.
Patrick Wong, head of China sales and business development
HSBC Securities Services
The China A-shares market is the second-largest equities market in the world, with market capitalisation of $8.8 trillion (as of end of March 2018). With such a large market, China is still heavily under-weighted in the global indices. Definitely, market access needs to be further improved.
Currently, MSCI has included those China A-shares eligible under the Stock Connect programme into their benchmark indices. Overseas investors have expressed that Stock Connect is an easier channel for accessing China A-shares. In order to further facilitate this, there are several points for developments, including removal of daily quota; further expansion of the scope of China A-shares under the Connect programme and matching the holiday gaps between China and Hong Kong.
A daily quota poses uncertainty to investors while accessing stocks, particularly during index rebalancing day. Expanding the daily quota to Rmb52 billion is a good move, but this would still hinder a bigger scale of weighting.
Further expansion to cover all China A-shares by the Connect scheme is another plus. This will enhance the whole universe of China A-shares eligible for index inclusion.
Matching the holiday gaps between China and Hong Kong under the Connect programme would further reduce the uncertainty of market movement during times when the China market is up but Hong Kong is on holiday.
Julien Kasparian, head of securities services for Hong Kong
It is not hard to argue that the current weightings of China A-shares within the MSCI are likely to grow.
Firstly, given the size of the Chinese market – the second-largest equity and bond markets in the world – it is completely logical for the major index firms to include Chinese stocks and bonds.
Secondly, the Chinese authorities have remained committed to the steady internationalisation of the markets and improved access routes for offshore investors (Stock Connect, CIBM Direct and Bond Connect for now, and the London-Shanghai Stock Connect to be added later this year). These cross-border schemes have created options that are more aligned with global standards enabling index managers to take these decisions.
BNP Paribas has seen a significant increase in the number of clients opening accounts and readying themselves for MSCI inclusion next month and the Bloomberg Barclays Global Aggregate Index next year. We have seen interest from both passive and active managers who are planning to increase their A-share activity, and an increase in both inbound and outbound investments.
Even with the absence of real-time delivery versus payment (DVP) for onshore China bonds, growth has been impressive as parties continue to ready themselves for the coming enhancements. Work is being completed to meet international needs for DVP in all market solutions, and to provide improved funding and liquidity solutions. These will be important for investors to gain comfort that the investment risks are manageable and could be a key factor in encouraging indices to add or increase China weightings.