Pensions & Investments published a special report in January 2018 about the "big interest" in domestic Chinese equities, predicting that the handful of active A-share searches by U.S. defined benefit plans would soon turn into a wave as institutional investors proactively realigned portfolios to better reflect China's importance. Then, markets were hurt by trade tensions with Washington as well as concerns over Beijing's ongoing deleveraging efforts.
With an eye on the longer term, however, a growing number of institutions have been engaged in discussions about allocating to China A shares listed in Shenzhen and Shanghai, a market that has a low correlation with major global equity markets and has the potential to add meaningful portfolio diversification. U.S. institutional investors had $652 million allocated to China A-shares strategies, including inflows of $33.6 million in the 12 months up to the end of September, according to eVestment. The increasing interest in Chinese equities follows MSCI's inclusion in June of China A shares to its MSCI Emerging Markets index for the first time. Based on MSCI guidance, China A-shares weighting of less than 1% will rise to 2.8% in August and to 3.4% in May 2020.
Why should institutional investors get ahead of these shifts by boosting allocations to China generally, and to China A shares specifically? For starters, MSCI's weightings don't even come close to reflecting the importance of a domestic Chinese stock market that has a market cap comparable to Europe's and an economy that is forecast to be the world's largest by 2030. Allocating to China A shares is especially important because the companies these shares represent are more heavily exposed to China's ongoing shift from an export-driven economy into the so-called "new economy," with its higher-value-added sectors, such as hospitality, health-care equipment, industrial automation, new energy vehicles, biotech, software and smart manufacturing.
Notwithstanding recent market turbulence, we view this opportunity to be as momentous as investing in emerging markets was a quarter century ago. What makes China A shares so attractive is, we believe, the combination of potential diversification benefits and Beijing's historical record of delivering on its growth and development plans. Diversification stems from the low correlation between China A shares and major equity indexes, from U.S. to Japanese and European stocks (Exhibit 1). Those low correlations may persist for two reasons. First, the China A-share market is still in its infancy, dominated by retail investors. Second, these firms derive about 90% of revenues locally, making them more sensitive to Beijing's domestic monetary and fiscal policies than the policies of the U.S. and other Western authorities.