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MSCI inclusion moves China onto global investment stage

Geoffrey Wong of UBS
Geoffrey Wong called China’s markets a ‘happy hunting ground’ for skilled managers.

MSCI Inc.'s decision to give Shanghai- and Shenzhen-listed A shares their first toeholds, however small, in the New York-based company's benchmark indexes marks a coming-out party for China's capital markets on the world stage, market veterans say.

"With this inclusion, China is effectively open to the world, and investors are going to come in with the bridge that we build," said Chia Chin Ping, MSCI's Hong Kong-based head of Asia-Pacific research, in an interview.

MSCI announced early June 21 in Asia that it will add an initial, select weighting of 222 large-cap names to its widely tracked Emerging Markets and All World Country indexes, among others, in two steps between May and August 2018. For its three prior annual reviews, MSCI had declined to include A shares in its indexes, citing accessibility issues.

The inclusion of roughly 5% of China's A-shares market — the world's second-biggest with a market capitalization of roughly $7 trillion — will leave it accounting for a scant 0.73% of an MSCI Emerging Markets index tracked by $1.5 trillion of institutional money globally, 0.1% of the firm's ACWI and 0.83% of MSCI's Asia ex-Japan index. If the market is fully included, on the back of continued market opening moves by China, it will account for more than roughly 17% of the Emerging Markets index.

More than an MSCI decision, the move is "basically an endorsement from investors on the accessibility of A shares," said Mr. Chia. "It's now an opportunity set (that) everybody will need to look at," he added.

The small weighting and MSCI's decision to focus initially on large-cap, liquid companies — in contrast to previous proposals that included mid- and small-cap stocks — allowed money managers and asset owners to look beyond some outstanding concerns, such as daily limits on repatriating capital and the frequency with which smaller companies on the mainland have suspended trading in their shares in recent years.

Meanwhile, active managers tracking the MSCI EMI will be free to take their time getting acquainted with the A-shares market, as the 0.73% weighting makes tracking error from not having exposure there a relatively minor problem for now.

Still, if that first step toward A-shares inclusion is largely a symbolic one, market veterans said it is significant.

"While the initial number and the starting weight of A shares is small, the inclusion nevertheless marks the beginning of an era," wrote Qi Wang, the Hong Kong-based CEO of Chinese equities investment boutique MegaTrust Investment (HK), in an emailed analysis of MSCI's A-shares decision.

"Global investors have largely ignored ​ the Chinese onshore market," with a combined stake of just 1.5%, but MSCI's decision confirms "the gravitational importance" of that market, agreed Karine Hirn, a Hong Kong-based partner with emerging and frontier market investment manager East Capital.

Exposure automatically

Investors in passive MSCI-benchmarked emerging markets index funds or exchange-traded funds will get exposure to A shares automatically when that initial weighting is implemented. MegaTrust Investment's Mr. Wang estimates net passive emerging markets index flows to A shares will amount to roughly $2 billion for the May-to-August inclusion next year.

An MSCI spokesman said with $4.7 trillion in institutional allocations globally to MSCI's Emerging Markets, ACWI and Asia ex-Japan indexes as of Dec. 31, net inflows for A shares resulting from the inclusion of those 222 large cap stocks could come to $17.4 billion.

In Asian trading, the MSCI news seemed to help the Shanghai and Shenzhen stock markets dodge a wave of selling for bourses in the region on June 21, with the Shanghai composite gaining 0.52% and Shenzhen climbing 0.43%. Markets in Australia, Hong Kong, India, Japan, Korea, Singapore and Malaysia finished lower that day.

While the potential flows from MSCI's A-shares inclusion look set to be modest, they can only get bigger with the likely addition of more of the market to the firm's indexes in coming years.

"How the inclusion factor grows over time will be a factor to keep an eye on," said Jeik Sohn, Hong Kong-based investment director, Asia, with M&G Investments, about the MSCI decision.

Mr. Chia said the path China has taken in opening its markets — with a bevy of access points, including the Hong Kong-Shanghai and Hong Kong-Shenzhen stock connect programs, established in recent years — is sufficiently unique to make previous examples, such as the five or six years it took to fully include South Korea's and Taiwan's stock markets in the benchmark, of little use in predicting the future.

Points that money managers could overlook with an A-shares EMI weighting of less than 1%, such as repatriation limits, would become matters of considerable concern if that weight were set to grow 10-fold. Topics like that will remain on the table as MSCI looks to include larger chunks of the market to its indexes, Mr. Chia said. Likewise, being able to access futures and options contracts based on the MSCI indexes on the mainland isn't a big issue at present, but as China inevitably becomes the biggest part of the index, that too will become an issue, he said.

Still, if challenges remain, "the most difficult step is the first step ... and once you've taken the first step the rest becomes a lot easier on a relative basis," said Mr. Chia.

Kinger Lau, Hong Kong-based chief China equity strategist with Goldman Sachs Group (GS) Inc.'s macro research team, in a report on the MSCI decision headlined "The equity long march official begins," predicted A shares could account for 9% of MSCI's Emerging Markets index and 1% of its All World Country index within five years, leading to $230 billion in net inflows.

Change the market

Institutional money could help change the character of a market that has remained dominated by retail investors, market veterans said.

In an analysis of the MSCI decision, Bin Shi, Hong Kong-based managing director, China equities, with UBS Asset Management, said the "long-term impact is more significant as global investors will bring a different kind of capital (long-term oriented, more fundamentally driven approach) to the A-shares market," changing the market structure significantly. Disclosure and corporate governance will improve considerably, he predicted.

For institutional investors overseas, that could be a mixed blessing, warned his colleague, Geoffrey Wong, UBS' Hong Kong-based head, Asia-Pacific and global emerging markets equities.

Mr. Wong said in an interview that institutional investors tracking the MSCI Emerging Markets index who use the small weighting MSCI is proposing as a reason not to add A shares to their portfolios now are "missing the point."

"The point isn't about tracking error due to the index weight being so small. It's really about the investment opportunity" offered by "the only large, liquid, inefficient market in the world now ... a happy hunting ground" for skilled managers, Mr. Wong said.

He said for the 12 months through May 31, UBS' A-shares strategy has surpassed the MSCI A-shares index by 37 percentage points, and added an annualized 10 percentage points of alpha for the past 10 years. A spokeswoman for the firm said the strategy's assets under management have doubled over the past year to $1.4 billion, helped by $390 million in net inflows. She declined to name any clients but said they include a mix of sovereign wealth funds, European pension funds and retail investors.

A lot of institutional investors overseas read the headlines — about China's huge debt problem or the frequent suspensions of trading by listed companies on the mainland — and avoid what they see as "a casino," said Mr. Wong. While those are real issues, an active manager can avoid the most vulnerable companies with solid fundamental research, he said. By way of example, when roughly half of listed companies on the mainland suspended trading in their shares when the market collapsed in the second half of 2015, only one of the 50 companies in UBS' A-shares portfolio did so, he noted.