China's economy is now the world's second largest, and the greater China equity market — comprising mainland China, Taiwan, Hong Kong and Macau, at approximately $6.1 trillion in market capitalization — already has surpassed Japan's as the world's second biggest.
Yet, exposure to China equities by U.S. mutual funds stands at only $100 billion as of June 30, as estimated by EFPR Global. This represents just 0.0008% of the estimated $12 trillion in U.S. mutual fund assets and a mere 0.016% of the $6.1 trillion China equity market.
There are valid reasons for the lower representation of China equities, to date, in the MSCI All Country World and MSCI Emerging Markets indexes, two major benchmarks on which many U.S. pension fund allocations are based. Both benchmarks are constructed primarily based on market capitalization and the historical free float. The MSCI ACWI and Emerging Markets indexes exclude a material portion of the China equities opportunity set — mainland Chinese equities, or A shares. China A shares represent the largest Chinese equity market with more than 2,000 active companies and more than $3.5 trillion in total market cap.
China, historically, severely restricted foreign investors' access to A shares by imposing a quota on the amount of shares available to qualified foreign institutional investors. This allowed China to maintain tight control on capital flow and regulate cross-border securities investment.
As a result, investors pegged to both indexes typically have missed out on more than 50% of the greater China equity opportunity set.
This trend is beginning to reverse as the demand for foreign institutional investors entering the Chinese market continues to increase with the expansion of China's economy and growth of China's capital markets. The Chinese government has indicated its intent to further promote stable development and open up China's capital markets by attracting overseas long-term investments that can create value. During the past six months, Chinese authorities have raised the QFII quota by $50 billion to $80 billion. We anticipate further easing in the months ahead and, as a result, China equity allocations and QFII applications by foreign pension plans are expected to increase.
We believe the additional access to China A shares comes at an opportune time for investors. From 2008 to 2011, the China A share market measured by the CSI 300 (a cap-weighted index designed to replicate the performance of 300 stocks traded on the Shanghai and Shenzen stock exchanges) has declined more than 56%. During that time, real GDP in China increased 44% and total earnings growth for listed companies in the China A share market rose approximately 80%, with a compound annual growth rate of 15.8%. With 12-month forward price-earnings ratio at 8.8 for the MSCI China index and 10.5 for the CSI 300, valuations are now at historical lows and the opportunity for bargain hunters has expanded. The current trailing 12-month p/e ratio is 9.2 for the MSCI China index and 12.2 for the CSI 300, among the lowest ratios during the past 10 years.
China's long-term economic growth will likely be driven by the gradual balancing of regional disparities, as higher growth is expected in China's Central and Western regions.