MSCI's decision this month to once again delay adding China's A shares to its emerging markets indexes could favor the small vanguard of U.S. institutional investors already fishing for alpha in that country's deep, inefficient stock market, analysts say.
When A shares eventually are included in those widely tracked indexes, the “vast majority” of U.S. investors still on the sidelines will begin seeking exposure there, making a market that's “wildly inefficient” now more challenging to squeeze alpha from, said Timothy Bruce, director of research with Boston-based investment consulting firm NEPC LLC.
MSCI's June 14 announcement — which praised China's recent reforms while stressing the need for more — should leave that overseas investor allocation spigot at a trickle for now, delaying the A-shares market's emergence as a more efficient price-setting mechanism, analysts said.
Still, inefficiency has its advantages. With local retail investors accounting for roughly 90% of the turnover for the more than $7 trillion of shares listed on exchanges in Shanghai and Shenzhen, and opaque regulatory moves frequently setting the market's direction, active money managers have been able to shine.
According to Ying Tan, a Hong Kong-based director of manager research with Mercer Investments, the median manager in Mercer's A-shares universe has delivered annualized returns of 4 percentage points above the benchmark CSI 300 index of Shanghai- and Shenzhen-listed shares over the past four or five years.
In more efficient markets, such as those for U.S. large-cap stocks, by comparison, the median manager often underperforms the benchmark.
Mr. Bruce said NEPC's consultants have made their clients aware of the window of opportunity that the market's inefficiency offers, while emphasizing that a considerable tolerance for risk is required to stomach the attendant volatility.
By way of example, the CSI has experienced annual moves of more than 20% for five of the past nine years, with gains of 176%, 97% and 48% in 2007, 2009 and 2014, respectively, and declines of 64% and 22% in 2008 and 2011.
Amid that volatility, the bulk of the roughly 75% of NEPC's clients with actively managed emerging markets equity exposure have chosen to monitor the A-shares market for now. Only a handful of clients have found the opportunities there compelling enough to push ahead with allocations, Mr. Bruce said. He declined to name them.
However, the staff of one of the firm's public fund clients, the $20 billion San Francisco City & County Employees' Retirement System, recommended May 9 that its board approve $200 million allocations to two Beijing-based managers, Cephei Capital and Springs Capital, contending that those firms were capable of exploiting the A-shares market's inefficiencies to deliver outsized returns.
Mr. Bruce said local managers could retain some advantages for now. “To really get this market, be able to invest in it, time the market, it takes a lot of insights beyond individual companies,” he said, such as a need to understand the Chinese consumer or the market psyche.
In documents presented to the board, the San Francisco pension fund's staff cited Cephei and Springs Capital's strong bottom-up research capabilities but also “good communications with government officials, including regular meetings to closely monitor macro and policy updates.”
San Francisco's staff predicted Cephei could produce annualized returns of more than 12% over the coming three years, while Springs Capital could deliver returns of between 15% and 20% over the same period.
As of late June, San Francisco's board had yet to act on those recommendations.
Wilson Chen, a Singapore-based manager research consultant with Cambridge Associates, said in a telephone interview that the quality of A-share managers' returns should increasingly come into focus, as the “information asymmetry” in China's inefficient markets inevitably reduces over time.
Going forward, investors likely will have to temper their return expectations and focus more on how returns are generated — whether, for example, practices such as insider trading are behind consistently strong results, Mr. Chen said.