As MSCI announces its decision to quadruple China A-share inclusion factor in its major benchmark indices, Greg Kuhnert and Wenchang Ma, co-Portfolio Managers of the Investec All China Equity Strategy, answer key questions on why they believe this sharp increase represents a milestone in the evolution of China’s domestic equity capital markets, and its significance for global investors
1) What will the increased weighting of China A-shares mean for the broader MSCI indices?
MSCI has announced that it will quadruple the China A-share inclusion factor in its major benchmark indices to 20% in 2019. This comes only one year after its initial inclusion of 233 large cap Chinese onshore stocks into its indices. This decision exceeds market expectations on the pace and size of inclusion. Additionally, FTSE Russell will also start phased inclusion from June 2019, which will see China A-shares representing 5.5% of its emerging markets index.
To put the scale of the MSCI move into context for global investors, at a 5% inclusion factor, A-shares currently make up around 0.8% of both the MSCI Asia Pacific ex Japan and MSCI Emerging Markets indices as well as 0.1% of the broader MSCI All Country World Index1. With a 20% inclusion factor – these weights will increase to more than 2.8% for MSCI Asia Pacific ex Japan and MSCI Emerging Markets by August this year with MSCI All Country World Index creeping towards 0.5%. The addition of more mid-sized Chinese companies will lift the weightings in the MSCI Emerging Market and Asia Pacific ex Japan indices above 3% by November 2019.
Eventually, if fully included, China A-shares would account for more than 18% of the MSCI Asia Pacific ex Japan Index, 16% of the MSCI Emerging Markets Index and 2% of the MSCI All Country World Index. It would also account for more than 20% of the Russell Emerging Markets Index.
2) What’s the significance of this index incorporation for global investors?
The MSCI inclusion process continues to constitute a key milestone for both A-shares and for investing in China’s domestically listed companies, in our view, for several reasons.
Although more and more investors, both institutional and retail, are considering strategic allocations to China, they remain underweight despite moves to open capital markets and make investing in China easier. Whilst schemes such as Hong Kong-Shanghai Stock Connect have allowed foreign investors to play a more prominent role in the A-share market, their participation is still very low. Currently, foreign investors hold just 3% of all A-shares, according to a recent survey. In our view, this is highly likely to change in the coming years as global index providers gradually include A-shares in regional and global benchmarks.
Given China’s strategic importance, attractive long-term growth potential, increasing index inclusion and diversification benefits, we think global investors’ allocation to the world’s second-largest equity market will grow over time. Increasing foreign investors’ participation should help reduce market volatility and improve pricing discovery in the A-share market.
3) What’s different about A-shares?
First, A-shares trade in renminbi. Second, A-shares differ from legacy tools used by international investors to gain access to Chinese equities (B and H shares, red chips, P chips and ADRs) in both the type of companies they represent and their investor base. Third, the exposure of the asset class – by virtue of the stocks listed in onshore markets – is tilted towards domestically focused sectors, such as consumer and healthcare stocks as well materials and industrials2.
Another important point of differentiation is derived from the considerable difference in the investor base of A-shares. The A-share investor base is heavily retail focused, meaning the market reacts to market events and information differently to markets with a larger institutional investor presence. Overall 81% of A-share volumes come from retail investors, nearly three times that of offshore-listed H-shares3.
4) What are the opportunities and the risks?
When it comes to evaluating single stocks, reasonable valuations are normally a good starting point. Indeed, an increasing number of opportunities have emerged in China after the major correction of 2018. We believe earnings will be the key driver of market returns over the course of the current year. The evidence suggests that quality companies with attractive valuations, improving operating momentum and increasing investor attention have tended to outperform over the long term and this remains the framework for our stock selection. Our 4Factor screen currently highlights China as the top market in Asia and sees most opportunities in industrials, communication services, utilities, energy and consumer staples sectors.
Clearly, the Chinese equity market faces short- to medium-term risks, most significantly policy execution and the recalibration of the trade relationship between the US and China. While we do not aim to predict how geopolitics may shape up over the near term, over the long term, we believe a consistent investment strategy focusing on identifying high conviction ideas, using a bottom-up approach, is the best way to provide long-term risk-adjusted returns to our investors.
Our investment process generates ideas from a broad range of sectors, covering both new and old economy segments. Fundamental analysis, combined with objective screening, will continue to drive new investment ideas for our portfolio.
1 Based on data used for MSCI’s May 2018 Semi-Annual Index Review
2 MSCI April 2018
3 CICC, Shanghai Stock Exchange, June 2017