Chinese A shares — stock listed on mainland exchanges — are an increasing focus of the major index providers, with both FTSE Russell and MSCI Inc. providing provisional indexes for incorporating this portion of the Chinese equity market into their broad emerging market benchmarks.
I've helped lead my firm in taking a position against the inclusion of China A shares into these benchmarks. Part of this resistance was based on the seeming bullish mentality by the index providers, which led them to make exceptions to their own admissibility criteria. Another concern was the sheer size that A shares would represent in the resulting indexes. This would cause most investors to hold roughly 20% of their emerging markets exposure in markets that were distinctly investor unfriendly, especially when the main method of market access was a quota program, found in no other country, had limited redemptions and had a “use-it-or-lose-it” feature problematic to the investment style of most asset managers. This combination of investor-unfriendly market dynamics paired with a large market size is somewhat anomalous. It appears that index providers have primarily focused on the size of the Chinese marketplace, rather than on the lack of investor access and protections, when considering the inclusion of A shares into their indexes.
The establishment by Chinese authorities of the Shanghai-Hong Kong Stock Connect program marked a meaningful advancement in accessibility to the Chinese A-share market. With the connect program, access was opened to a wider array of investors, and officially required much less in the way of regulatory filings on the part of the foreign investor. Since its launch in 2014, program volumes have grown, and this venue now appears to offer a viable alternative to the quota-based program. This evolution has taken away a portion of our concerns around market access; however it should be noted a quota still exists on trade volumes allowed in the connect program, and the entire A-share market is not available through the connect program.
Pros and cons
Given this development, it is worth reconsidering the pros and cons of including A shares in a diversified emerging markets portfolio. On the plus side, A shares have demonstrated low correlation with Hong Kong-listed shares, as well as the equities of other emerging market countries, yielding a diversification benefit to the broader portfolio. Also, the A-share market allows an investor access to a broader representation of economic sectors within China than available from non-mainland exchanges. On the minus side, there exists material currency repatriation risk with respect to the Chinese yuan, and market access and investor protections are extremely primitive when compared to other emerging markets.
These market conditions on their own do not disqualify A shares from inclusion. Our firm has invested in the least developed capital markets for more than 20 years, incorporating static allocations to a large number of frontier market countries. If we reframe the A-share decision as, “are connect-listed A shares riskier than a frontier market country,” it is obvious they are not. However, as the events of last summer demonstrated, they are also not substantially less risky. By treating A shares like we would any other frontier market, which I believe is the closest analogy, a small position, roughly 1%, best balances the diversification benefit of A shares with the inherent political, economic and liquidity risk one takes on when investing in mainland exchanges.
As it stands, the current transitional index from MSCI starts with an allocation to A shares of about 1%, and then grows this allocation as market conditions are liberalized. While this initial allocation appears appropriate, as this allocation grows, investors would be well-served to make sure that they are in agreement with the assessment of the index providers, and if not, to move to either a benchmark that excludes A shares, which MSCI currently states it will continue to provide, or whose A-share sizing best reflects their opinion. To do otherwise would amount to blindly accepting a major allocation to a market that has shown little interest in the rights of foreign investors.
Timothy Atwill is head of investment strategy at Parametric Portfolio Associates LLC, Seattle.