A-shares success sets the stage for MSCI expansion

MSCI Inc.'s inclusion of an initial sliver of China's Shanghai- and Shenzhen-listed A shares to its benchmark indexes midyear came off without mishap, clearing the way in quick succession for a more substantial follow-up over the coming year.

MSCI's first toe in the water — adding 5% of the market between June and September to its widely tracked global emerging markets index — was "extremely smooth," with consistently good feedback from investors, said Chia Chin Ping, MSCI's Hong Kong-based head of research for the Asia-Pacific region.

In an expeditious move to build on that success, MSCI will consult with money managers and investors through mid-February 2019 on a proposal to quadruple, to 20%, the share of large-cap stocks listed in Shanghai and Shenzhen to be included in the index. That second step would raise the large-cap weight to almost 3% of the index from just more than 70 basis points at present.

Another 7.5% of the A-shares market could be added to the index in both May and August of 2019. The New York-based company said it will announce a final decision on how to proceed by Feb. 28.

Mr. Chia said the flawless execution of the initial A-shares inclusion has given MSCI confidence to fast-track the process. The "very good feedback" MSCI got following the first round of inclusion will "enable us to move a lot faster," both in terms of timing and the scale of the follow-on step, said Mr. Chia.

That first move — at a less than 1% index weighting — was sized to give asset owners not yet comfortable investing in mainland-listed shares room to remain on the sidelines without incurring undue tracking error risk.

While that negligible weighting could have left a lot of investors sitting out the first round, "the numbers that we see seem to suggest otherwise," said Mr. Chia.

Data provided by MSCI and the Hong Kong Stock Exchange showed the value of A shares held as of Sept. 30 by offshore investors — using the Stock Connect program China launched in 2014 to give Hong Kong-based managers and asset owners access to mainland-listed shares — surging to 665 billion renminbi ($96 billion) from 347 billion renminbi just ahead of MSCI's June 2017 announcement that it would add A shares to its indexes in 2018.

Those figures suggest strong interest and strong inflows, especially when this year's 20% retreat in the A-shares market is taken into account, said Mr. Chia. More than half of those flows have come from active investors, he added.

Battered in part by an incipient trade war between the U.S. and China, at the close of Asian trading Nov. 8, the Shanghai Stock Exchange composite was down 20.31% for the year while the Shenzhen Stock Exchange composite was off 29.77%.

Managers of A-shares-focused strategies in the region confirm a pickup in institutional client interest this year.

A spokeswoman for Aberdeen Standard Investments said her firm's A-shares strategy, managed by Hong Kong-based portfolio manager Nicholas Yeo, has seen its assets under management jump to $1.8 billion currently from around $1.1 billion a year before.

Over that span, the mix of institutional to retail and high-net-worth clients has risen to 30%-70% from 10%-90%, the spokeswoman said, with institutional investors accounting for more than half of the $700 million rise in AUM over that period.

Another sign of growing interest from offshore investors is the number of accounts opened in Hong Kong to trade directly with the mainland, which have almost quadrupled to more than 6,300 from 1,700 at the time of MSCI's June 2017 announcement of its initial inclusion plans.

Those numbers don't offer a precise measure of how many investors are coming to the table because a single asset owner can open accounts for each of its external managers. By way of example, Matthew Liposky, chief investment operating officer with the $71.8 billion Boston-based Massachusetts Pension Reserves Investment Management Board, said in an interview that PRIM set up eight accounts this year ahead of MSCI's initial inclusion in June to allow its emerging markets managers to trade directly in mainland-listed stocks.

Mr. Liposky said an asset owner would need to set up an account for each of its segregated account managers investing in A shares on PRIM's behalf.

Market veterans say asset owners such as PRIM are in the vanguard. Matthew J. Coburn, a Boston-based vice president and relationship executive with BNY Mellon Asset Servicing, said in an email that PRIM, a public fund that operates its investment strategy along the lines of an endowment, is one of only a minority of asset servicing clients — perhaps a dozen or so — that have moved to open Hong Kong Stock Connect trading accounts so far this year in response to MSCI's initial inclusion.

Mr. Coburn predicted the number of asset owners doing so will pick up going forward as more clients complete their due diligence on the Hong Kong Stock Connect option.

Even if the impact of that rise in the number of accounts to 6,300 from 1,700 is tough to measure in an absolute context, it's still significant as a gauge of interest in the A-shares market, said Mr. Chia.

MSCI was the first major provider of global equity benchmark indexes to begin including A shares, but on Sept. 26, competitor FTSE Russell announced it also will add A shares beginning in June 2019. And FTSE Russell could be poised to add exposure more aggressively — it pledged an initial three-step "tranche" that will lift the weight of A shares in the FTSE Emerging index to 5.5% by March 2020, almost double the weighting MSCI is proposing for its follow-on inclusion.

Executives at MSCI and FTSE Russell say openness about including A shares in their indexes rests on confidence in China's Stock Connect program rather than earlier programs, such as the qualified foreign institutional investor mechanism.

Mr. Chia said the "robustness" of the Stock Connect program, its success in making the A-shares market accessible to foreign investors, is the main factor behind MSCI's "accelerating a little bit this inclusion."

FTSE Russell, in materials provided by a spokesman, said its initial inclusion will be based on 25% of each security's investability weight.

Mr. Chia said continued market opening by China's regulators will help determine the pace of further A-shares market inclusion.

One issue on the table — giving foreign investors access to tools such as futures and swaps to better manage the risks of exposures to the second-largest stock market in the world — will be more important as the weight of A shares increases.

At A shares' current market weighting of less than 1%, having access to exchange-traded funds, futures, swaps and options isn't something investors will lose a lot of sleep over, but at 20% inclusion of the market, A shares will have a weight close to that of Mexico or Russia, and it will become a much bigger issue, Mr. Chia said.