The Chinese government's recent strong-arm market tactics might push back the day when A shares garner a toehold in emerging markets indexes, but some money managers already are looking ahead to the day when the country's huge, vibrant equity market outgrows those indexes.
Many predict the same logic that saw Asia evolve into “Asia ex-Japan” in the 1980s, with the emergence of the region's first modern-day economic superpower, will come into play for China as well.
The weight of China in MSCI's emerging markets indexes will grow “in quite a visible way” over the next five to 10 years, effectively turning Asia ex-Japan into a Greater China index, said Mauro Ratto, a lead portfolio manager and London-based head of emerging markets with Pioneer Investments, in a recent interview. It will become a “super relevant market,” he said.
“We believe that investors should begin to consider … stand-alone strategic allocations to China,” said Eric J. Mogelof, a Hong Kong-based managing director with Pacific Investment Management Co. and head of PIMCO Asia Pacific. Active management, meanwhile, "will be critical in this market, due to the importance of security selection," he added in an email.
For Vanguard Group Inc., which announced June 2 it would migrate its $64 billion emerging markets index fund to a FTSE benchmark with a provisional 5% A-shares weighting, “it's premature to comment on whether A shares/China should be broken out of any emerging markets category,” said spokeswoman Linda Wolohan in an e-mail.
A move of that scale into A shares, at roughly $3.2 billion, could have proven painful over the past month, as the market's plunge of well over 30% between June 12 and July 8 would have shaved more than $1.0 billion, or almost 2%, from the fund.
In a July 21 note on China's recent equity market volatility, Joseph Brennan, Malvern, Pa.-based principal and global head of equity indexing with Vanguard, said the fund has yet to start investing in A shares but will begin later this year, spreading its purchases over a 12-month period to average in the costs. The opportunity set, rather than the volatility of the moment, determines the fund's strategic allocations, he added.
In the same note, his colleague, Qian Wang, a Hong Kong-based economist, said the importance of A shares as a diversifier — on account of their “much lower and time-varying correlation with the rest of the global equity market” — should increase as that market becomes an ever-larger slice of the global opportunity set.
Francis Gupta, Princeton, N.J.-based senior adviser to equity research and index design firm MarketGrader Capital LLC, said in an interview his firm's research shows a decline in correlations between A shares and other emerging markets equities over the past three years, and more interestingly, a fall in correlations between China's two big equity markets of Shanghai and Shenzhen.
Further research is needed to determine whether the factors driving those correlation trends are idiosyncratic and temporary or structural, said Mr. Gupta. If the evidence suggests more permanent factors at work, then — together with the inevitable growth of China's equity market — it's harder to justify making allocations to A shares as part of a broader emerging markets allocation, he said.
Meanwhile, an argument can be made that institutional investors should consider specific allocations to Shenzhen's tech-heavy, smaller-cap market and Shanghai's more large-cap market, he said.
If the retail-dominated nature of China's mainland equity markets, combined with the limited access offered to foreign institutional investors and the nascent state of the domestic institutional landscape, are the reasons for the low correlations, then an eventual rise of institutional flows could bring A shares more in harmony with other emerging and developed equity markets.
In the same interview, Carlos Diez, MarketGrader's CEO, said China's government “recognizes the importance of institutionalizing this market,” to ensure that capital is channeled to the most promising private companies, a sector that accounts for almost all of the country's employment growth. That progress is “not going to happen in a straight line, but it is going to happen,” he said.
Toward that goal, growing investments from overseas investors can help, but they can only play a complementary role to the development of a robust, domestic institutional investor base, said Pioneer's Mr. Ratto.
