Decision to reduce weighting by half likely to tip the scales
China's domestic A shares should gain their first toehold in MSCI Inc.'s global emerging markets index when the New York-based company announces its annual benchmark index revisions on June 20, after three years of delays over market access concerns.
If those concerns are finally overcome on the fourth go-round as widely expected, MSCI's decision two months ago to halve its proposed A-shares index weighting to 50 basis points will have helped grease the skids for China's inclusion, industry veterans say.
A weighting that small would amount to token exposure for the world's second-largest stock market, but the move would still be highly significant, contend offshore money managers investing in Shanghai and Shenzhen-listed shares.
Even if MSCI's latest proposal is a “watered-down version of its earlier proposal … it should still be a watershed event for the Chinese stock market,” said Wong Kok Hoi, founder and chief investment officer of Singapore-based APS Asset Management Pte Ltd., in a note to clients in early May.
If that marginal weighting's immediate import is largely “symbolic,” it would still mark the beginning of China's inevitable rise in global portfolios, even as it allows investors focused on remaining irritants — such as the 20% monthly limit on repatriations of capital invested under China's qualified foreign institutional investor program — to sit out for now without fear of underperforming the benchmark, agreed a Hong Kong-based institutional salesman with a global money manager who declined to be named.
If A shares are included in the MSCI index, it will be more “a turtle race” than “off to the races,” said the institutional salesman. But the fact that “the race has begun” will be important, and whether it's this year or next year, it probably won't be much longer than two or three years before “people … really start to get serious” about adding A shares to their portfolios, he said.
“The short-term impact will be small,” agreed Mr. Wong, “but investors will start preparing for the day China A becomes a significant part of the indices — not just global emerging markets. Today, most foreign investors don't have a single resource allocated to track China A,” he said.
'A lot of progress'
Chia Chin Ping, MSCI's Hong Kong-based head of research for Asia, declined to comment on any decisions regarding China inclusion that MSCI is considering in June. But in a May 24 interview with Bloomberg, his boss, Henry Fernandez, MSCI's chairman and CEO, said nothing is certain at this point. MSCI's talks with China are making “a lot of progress on all fronts … (but there are) still a lot of issues to resolve in a short period of time” to achieve that first crucial step on including A shares, he added.
Before its latest proposal in March, MSCI had weighed adding a 5% chunk of China's A-shares market to its global emerging markets equity index. That proposal would have left locally traded stocks on the mainland accounting for roughly 1% of the index.
The new proposal would add 169 large-cap companies making up roughly 2.5% of the market, compared with the 448 small-, mid- and large-cap stocks under MSCI's previous proposal.
Other countries added to MSCI's global emerging markets index in recent decades took five or six years to integrate fully. An initial 20% of Korea's stock market was added in 1992. That was raised to 50% of the market in 1996 and 100% in 1998. For Taiwan, an initial 50% of its market was added in 1996, followed by three additional tranches culminating with 100% coverage in 2002.
According to MSCI, if 100% of China's A shares market were included in its global emerging markets index, it would account for more than 18% of the index and almost half of an expanded 39.9% for China, including the shares of Chinese companies listed in Hong Kong and New York.
Interest among global institutional investors will increase if MSCI includes China A shares in its indexes, but a huge amount of education will be needed to serve those investors, said Rene Buehlmann, Hong Kong-based group managing director and head, UBS Asset Management Asia-Pacific, in a recent interview.
Mr. Buehlmann said UBS is planning a “significant road show” for the third quarter to discuss what UBS Asset Management has built in the region to invest in China.
And while institutional investors allocating to passive emerging markets strategies will automatically get A-shares exposure once MSCI includes those shares in its index, money managers predict China's local markets will ultimately prove a bigger lure for asset owners hunting for alpha.
“When you say 'where is alpha?'” China's A-shares market will end up on many radar screens because “that's the market where information is not that efficient yet,” said Mr. Buehlmann.
Projit Chatterjee, a Singapore-based managing director and senior equity specialist, global emerging markets and Asia-Pacific equities, with UBS Asset Management, in a separate interview said over the long term, that promise of market-beating returns from A-shares allocations “will play out,” but investors have got to be able to stomach short-term volatility to get that payoff.
Over the past three years through April 30, the $1.2 billion A-shares portion of UBS Asset Management's China equity business outperformed its MSCI A-shares benchmark, net of fees, by an annualized 9.6 percentage points, double the still considerable alpha delivered by its $2 billion China Opportunity Fund, which focused on Chinese companies listed in Hong Kong and New York, said Mr. Chatterjee.
For the most recent 12 months through April 30, the corresponding alpha numbers were 25.1% for UBS' China A-shares strategy and 0.5% for the China Opportunity Fund, but for the five-year period, China opportunity edged out the A-shares strategy 8.5% to 7.1%, he said.
“My clients use APS because they believe in the inefficiencies” of a China A-shares market where retail investors account for more than 80% of trading, agreed APS' Mr. Wong.
Ying Tan, a Shanghai-based principal, China investment business and manager research, with Mercer Consulting (China) Ltd., said in an email that her analysis showed the median manager in Mercer's China A shares manager universe besting the returns of MSCI's China A total return benchmark index by an annualized 4.9 percentage points over the past five years.
That supports the contention that active management “can deliver good alpha” in an inefficient, retail-dominated market, she said.
The Hong Kong-based institutional salesman said growing institutional inflows in coming years may chip away at the broad inefficiency of the market, but for the next 10 years at least, China A shares should remain a happy hunting ground for skilled managers.
Meanwhile, investors will likely be grappling with how to integrate local Chinese shares into their portfolios at the same time China's bond markets are being added to global sovereign bond indexes.
In a May 24 research note, Wilfred Wee, a Singapore-based portfolio manager, emerging markets fixed income, with Investec Asset Management, predicted China's $9 trillion government bond market will be added to leading global benchmark indexes over the coming two to three years.
This article originally appeared in the May 29, 2017 print issue as, "China A shares likely coming to MSCI EM index".