Charlie Awdry, China equities portfolio manager, discusses the implications of China A shares’ increased weighting in MSCI equity indices, and how this should lead to further foreign participation in China’s equity markets going forward.
What’s the news?
Index provider MSCI announced on 28 February 2019 that it will increase the weighting of China A shares (Shanghai and Shenzhen-listed stocks) in its indices by quadrupling the inclusion factor from 5% to 20% by November 2019*.
As a result of this, there will be 253 large cap and 168 mid cap China A shares in the MSCI Emerging Markets Index, which increases their weighting in the index from 0.7% to 3.3%. This is in addition to existing China weights in the index, from Hong Kong-listed H shares and New York-listed American Deposit Receipts (ADRs). In the event of full inclusion (100% inclusion factor), China A shares alone would account for 16.3% of the MSCI Emerging Markets Index based on current market capitalisations, meaning Chinese equities as a whole would exceed 40%:China’s increasing weight within the MSCI Emerging Markets Index
Source: Janus Henderson Investors based on MSCI index data, as at 29 February 2019
Note: Index weights taken at calendar year ends. China became the largest country weighting in 2007.
Note: *Hypothetical 100% inclusion (which may or may not occur in the future). China would comprise 42% of the index, based on current market capitalisation.
Shares listed on China’s tech-focused ChiNext, a Nasdaq-style board of the Shenzhen Stock Exchange, will also be included in the indices from May 2019.
Why is it important?
As outlined below, we expect the move to drive further positive change for the China equities market and for Chinese companies, resulting in increased investment from global investors.
The move is confirmation that the introduction of A shares into the MSCI indices last year has been positive and that access is improving for foreign investors. This is predominantly due to the successful roll-out of A shares on the ‘Stock Connect’ scheme, which facilitates mutual market access between mainland China and Hong Kong. The mechanism has proved both resilient and flexible, addressing many of the concerns that MSCI had about the alignment of the China A share market with international market accessibility standards.
Boosting China’s credibility
MSCI’s decision reflects broader reform in the country, as the government steps up its efforts to integrate China's capital markets into the global financial system.
The Chinese economy continues to slow, with guidance at the recent National People’s Congress targeting 6-6.5% gross domestic product (GDP) growth, down from last year’s 6.5%. But government policymaking has taken a pro-growth turn this year, with targeted plans to boost spending, cut taxes and open up foreign investor access to its markets.
This, together with an apparent softening in the US stance towards China trade tariffs, has led to a strong rally in the A share market this year, albeit from a low base following last year’s sell-off. The rally reflects the sentiment-driven nature of the A share market, which is dominated by ‘emotional’ domestic investors. It is this volatility that can make the A share market particularly difficult to navigate. However, due to its sheer size and depth, it is often the place where active managers can uncover the best opportunities.
Unlike local investors, foreign investors tend to take a longer term, fundamentals-based approach, preferring a sub-set of high quality businesses within these markets. With the increased institutional activity that the higher weighting is likely to bring, we expect some of these shares to re-rate and trade differently to the rest of the A share markets over time, with pricing inefficiencies correcting as the shareholder base becomes more stable.
Increased attention from, and participation by, foreign institutional investors in China’s domestic equity markets should help these markets mature, improving mutual knowledge and understanding while enabling Chinese equity issuers to improve corporate governance.
Diverse opportunity set
The A share market is complex and dynamic. With more than 3,000 listed companies, it is one of the biggest markets in the world and continues to grow apace. Reforms are likely to translate into an even bigger number of initial public offerings (IPOs) over the coming years.
Our team aims to uncover the best opportunities from across the Chinese equity market, investing in domestic A and B shares as well as overseas Hong Kong-listed shares and New York-listed ADRs. We already use Stock Connect, with approximately 15% of the strategies currently invested in A share-listed companies. We also have more than 5% invested directly in the Hong Kong Stock Exchange, which should be a key beneficiary of the increased inflow into the Stock Connect platform.
Mainland Chinese equity markets are opening up to foreign investors; investments that were not possible only a few years ago are now possible. We believe China’s increasing importance on the global investment stage should be a strong driver for investors to reassess their exposure and consider a separate allocation to a specialist China equity manager outside their emerging markets or Asia allocation. A specialist approach to investing in China can give a much broader and deeper exposure to dynamic Chinese companies.
*Index inclusion factor: the MSCI uses the standard index inclusion factor as part of its calculations to determine the weight of a security in the index. For example, with the index inclusion factor at 20%, each A share’s weight in the index will be 20% of its available free-float market capitalisation, adjusted for any applicable limits on foreign ownership.