China A shares seen moving quickly to take larger role with institutions

China A shares will debut May 31 as a bit player in MSCI's widely tracked Emerging Markets index, but if all goes smoothly they could take on a leading role in the not-too-distant future.

Money managers focused on China report a sharp expansion in the ranks of institutional investors globally taking notice.

For the moment, they say, the pickup in mandates has been incremental ahead of MSCI's move to add the first 2.5% of the Shanghai and Shenzhen equity markets to its index at month's end.

That modest uptick masks a fundamental change in attitude among institutional investors globally, promising more substantial inflows to come, they predict.

A year ago, investors viewed the question of A shares exposure as "not so material," but a growing number seem to have a sense of urgency now, rushing to complete their due diligence, said Wong Kok Hoi, founder and group chief investment officer of APS Asset Management Pte. Ltd., Singapore. The China equity-focused boutique had $3.1 billion in mostly institutional assets under management as of the end of 2017.

Those investors aren't looking at China's current weight in the index, which will be 40 basis points when that initial 2.5% of the mainland markets is included on May 31, and still a scant 80 basis points when another 2.5% is added at the end of August, said Mr. Wong. Instead, investors "are looking at the future China weight in the index," which eventually will exceed 16% when the market is fully included, he said.

After China's "almost inconsequential" debut, the country's weight in the index "will increase very quickly in coming quarters," Mr. Wong predicted.

Chia Chin Ping, MSCI's Hong Kong-based head of research for the Asia-Pacific region, in a May 21 interview, suggested that follow-on steps to further boost A shares' presence in the index could be mapped out as early as the second half of this year.

"For sure we want to wait, observe and make sure the initial inclusion is a success (but) after the end of August ... we're likely ​ to find an appropriate time to come back to the market to talk about the next phase of inclusion," Mr. Chia said.

Investment consultants report signs of growing client interest in A shares.

"We've definitely seen more queries and interest from our clients to look at China this year," with a number seeking dedicated China exposure, said Wilson Chen, a Singapore-based senior investment director with investment consulting firm Cambridge Associates.

Richard Dell, the London-based global head of Mercer LLC's equity boutique, likewise reported increased client interest in China, as well as a pickup in search activity.

Sell-side houses predict a pickup in active as well as passive allocations from global investors this year as a result of the MSCI inclusion.

A report by UBS Securities on May 14, the day MSCI identified the more than 230 large-cap A-share stocks to be added to its indexes, pegged the amount of resulting inflows to MSCI indexes at $18.4 billion — 20% to passive and 80% to active strategies.

Mr. Chia said that's roughly in line with the passive-active split for the $13.9 trillion in assets benchmarked to MSCI's family of indexes.

J.P. Morgan Securities predicted $8.5 billion in passive flows to MSCI indexes, and up to $40 billion in active flows over time.

Mr. Chia said there are signs — after five years of banging the drum for A shares — that foreign investors finally are ready to embrace them.

For example, the number of "special segregated accounts" opened by institutional investors on the Hong Kong Stock Exchange to buy and sell A shares through the HK-Shanghai Connect program surged to more than 4,000 in April from less than 1,700 only 12 months before. That "huge jump" in institutional accounts "gives us the sense that investors are actively getting ready," Mr. Chia said.

With the inclusion of A shares poised to add to China's almost one-third exposure in the index from Hong Kong-listed H shares and the American depository receipts of Chinese companies listed in New York, "the bigger question is whether investors should move away from the broad emerging markets mandate toward dedicated China exposure and emerging markets ex-China exposure," said Aaron Costello, a Beijing-based senior investment consultant with Cambridge Associates.

A Singapore-based institutional sales executive with a global money manager, who declined to be identified, said most of the pickup in client interest in A shares his firm has seen over the past six to nine months has been for exposure through existing Asian, emerging market and global equity mandates.

In contrast, a Hong Kong-based institutional sales executive with a China-focused boutique in the region said his firm is seeing a growing number of investors looking to "fire their global emerging markets managers" in favor of awarding mandates for China and emerging markets ex-China.