Connecting China to global capital – China A Shares index inclusion

13 September 2018

    MSCI's recent inclusion of China A Shares into its indices is a major step in connecting the Chinese financial system with the rest of the world.

    After years of waiting, Chinese domestic stocks have been added to some of the world's most important benchmarks. In 2017, index provider MSCI announced that it would include China A Shares into the widely followed MSCI Emerging Markets Index. The implementation took place at the end of May this year, with 234 stocks added to the index, which marks a deepening connection between China's financial markets and the rest of the world.

    The impact of including stocks from the stock exchanges in Shanghai and Shenzhen to the global benchmark was discussed at HSBC's 2018 China Conference. Representatives from index providers and stock exchanges characterised it as a development that will help integrate China's financial markets into the global system – affecting both active and passive managers.

    It will be a gradual process, with China A Shares accounting for just 0.4 per cent of the index. But full inclusion of the asset class would represent 16.6 per cent of the index. When added to the Hong Kong and US-listed Chinese companies, China's weighting will be 42.8 per cent, making it by far the biggest country on the index1.

    Understanding a unique market

    Index inclusion will attract many investors to China A Shares for the first time – an asset class that has generated strong performance in the past. China has historically been a major contributor to the growth of emerging market portfolios according to MSCI data, and a back-tested performance analysis by the index provider shows that the addition of China A Shares would have boosted gains even further. However, past performance is not a guarantee of future growth.

    The China A Share market has a different sectoral composition compared to Chinese companies listed offshore. In Shanghai and Shenzhen there is a higher proportion of so-called "New Economy" stocks than in Hong Kong – in industries such as healthcare and consumer staples. Investors should also be aware that a company that is listed in Hong Kong and Shanghai will likely not trade at parity in both markets.

    China's domestic market also has very different characteristics to other emerging markets, which typically have a low valuation, high dividend yield, along with a dependence on momentum. China A Shares by contrast, are characterised by high beta, strong growth, smaller size, as well as lower liquidity risks. Value has proven to be a significant driver of China A Share returns in recent years.

    Indices and factors

    Global capital will enter China as passive funds buy China A Shares to match the new composition of the index. Active fund managers will also have to reconsider the China A Share market as it will be a growing part of the benchmark that they use to measure performance. In particular, they will have to rethink their asset allocation policy and update the investment process.

    Some investors will do their own fundamental research on individual companies, while others will get their exposure via an indexed implementation or go for a quantitative factor-based investment process. The latter approach, is a particularly effective method for focusing on sections of the market that tend to outperform.

    There are a variety of indices that track the China A Share market currently available, each allowing fund managers to execute a different investment strategy. For investors who are interested in taking a gradual approach to China A Shares for example, there is the MSCI China Inclusion Index which represents the component that is being integrated into the MSCI flagship indices, according to speakers at the China Conference.

    Indices are also a useful tool for taking a factor-based approach to the market, which the conference speakers said is suitable for China A Shares due to the nature of the local investment community. Retail investors are responsible for the lion's share of trading, which creates opportunities for institutional investors that are able to spot the characteristics of undervalued stocks that individual investors tend to ignore.

    Other major China investment themes can be captured by factors – such as environmental, social and governance measures, which allow investors to exclude companies with a poor environmental record from their portfolio, or to allocate more to companies that score highly according to these metrics.

    Active investors looking to allocate to individual stocks will have to invest the time, money and effort to create a complete portfolio management capability that understands the local markets. The benefits of completing such a process could be a level of alpha hard to achieve in other markets.

    One reason that the China A Share market is viable for active managers is the difference in the value of stocks. In a homogenous market, it is harder to beat the market.

    Future developments

    The rate that China A Shares are included into international indices will depend on the speed which China continues to open up its markets. In particular, market access is a longstanding concern for investors looking to invest in China's domestic market.

    Unlike many other markets, where global capital faces no impediments, investors allocating money to China have to choose one of several routes into the country – from the original Qualified Foreign Institutional Investor (QFII) programme to the more recent Stock Connect routes into Shanghai and Shenzhen.

    Looking to the future, institutional investors will need access to the Chinese market to become more aligned with international standards before they accept a larger weighting of China A Shares into major indices. Looking to the future, a harmonised market access regime will therefore be a crucial factor for getting investors to allocate into China's domestic stock market.

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