After years of preparing for the inclusion of china in the MSCI emerging markets index, etf providers are taking things slowly, writes Lynn Strongin Dodds.
MSCI’s decision to welcome China’s mainland ‘A’ shares into its MSCI Emerging Markets Index next June came as no surprise. It had been well flagged for four years and the inclusion is a miniscule part of the index.
Investors have had ample time to gear up for the change, though ETF providers – many of whom already have Chinese offerings – may wait and see how the volumes unfold before launching a spate of new products.
“Everyone had been waiting for the announcement for a very long time,” says Adam Laird, head of ETF strategy at Lyxor Asset Management. “Many people expected that the MSCI [inclusion] would follow as soon as the Shenzhen Stock Connect was launched. What it means is that China is being accepted as a more mainstream market.”
He adds: “It might have happened sooner but events two years ago put a dampener on things, but investors have become more comfortable with investing in the country again.”
Markets were badly shaken two years ago when growth ground to the slowest rate in two decades, but the country has since rebounded.
“Investors have generally wanted an allocation to China and I think MSCI inclusion will accelerate the process,” says Danny Dolan, managing director at ETF manager China Post Global. “It will also lead to a differentiation between companies and those who pay greater attention to corporate governance will attract the greater inflows.”
Dina Ting, vice president for global ETFs at Franklin Templeton Investments, also notes that in the past, the size of allocations to emerging markets were low and did not reflect the contribution of these countries to the global economy. This is certainly the case with China, which has long been viewed as under-represented in global equity indices given its size.
At present, China accounts for a 3.5% weight in the MSCI All Country World Index, despite being home to the worlds’ second-largest stock market and an economy that accounts for 17% of global GDP, 11% of global trade and 9% of global consumption
However, MSCI is adopting a slow and steady course. As Chris Mellor, a product specialist at Invesco PowerShares, points out, “it is taking baby steps”.
The inclusion will begin in May with a 2.4% weighting. This will double in August, but together this only accounts for around 0.73% of the MSCI Emerging Markets Index, says Mellor. The index is tracked by an estimated $1.6 trillion in assets (€1.4 trillion).
Mellor adds: “The concern was that if it was too big a change, it would be difficult for investors to rebalance the portfolio adequately.”
There is more work to be done on the corporate governance front, a major stumbling block for China in previous discussions about inclusion. Investors will still have to be aware of undisclosed ownership structures, regular corruption scandals and exposure to unregulated shadow finance.
Behind the scenes, state influence is also thought to dominate corporate decisions.
Enough progress, though, has been made for the index provider to open the door at last. For example, the Chinese government has introduced rules that limit under what circumstances and for how long Chinese companies can halt trading. Investors were rattled and became wary of investing when – in the wake of the Chinese stock market crash in 2015 – the government suspended more than half of all stocks from trading and officials forced local institutions to contribute to a bailout fund.
President Xi Jinping has also made corruption one of his key planks since taking over the reins in 2012 and reiterated this stance in his speech to the Communist Party Congress in October. The campaign has led to the investigation and punishment of hundreds of thousands of government officials, but some observers also believe it has given him a way to eliminate key members of rival factions within the party.
One of the key catalysts has been the introduction of the Stock Connect programme, which debuted in November 2014 between the Shanghai and Hong Kong exchanges and was extended in late 2016 to encompass the Shenzhen market. It allows foreign investors to trade local China A-shares without an overall aggregate quota or capital mobility restrictions. Improved access is one of the main reasons the MSCI chose the link to trade the A-shares, rather than using the Qualified Foreign Institutional Investor (QFII)/RMB Qualified Foreign Institutional Investor (RQFII) programmes.
Historically, as research from iShares points out, foreign investors were limited to buying about half of China’s $8 trillion-plus equities market via H-share, Red-Chip, P-Chip and foreign listed equities. The remaining half, or A-shares, were available only under strict quotas set by the government.
“Choosing Stock Connect has made investors much more comfortable because it gives them the capacity to trade directly on either Hong Kong or Shanghai,” says Howie Li, CEO of the Canvas business at ETF Securities.
“I think MSCI is taking the same approach that they adopted to Taiwan, which was a slow process of integration that lasted about five years in order to minimise any disruptions. Although the limited China inclusion doesn’t capture all of the equity sectors, there are enough of them to give investors significant exposure.“
Overall, the index will include 222 mainland China-based companies that will be quoted in renminbi and listed on either the Shanghai or Shenzhen stock exchange. They represent around 5.5% of the total $7.3 trillion Chinese A-share market and analysts believe that although relatively small in number, they represent a broader picture of China’s real economy than the MSCI China Index, which provides exposure to large overseas listings of Chinese banks and internet companies.
The 222 companies cover a wide range of sectors, including industrials, health care, consumer staples, materials, IT, telecommunications and energy. In addition, they encompass several companies that are absent from the offshore universe, such as household furnishings, chemicals, renewable power producers, biotechnology and pharmaceutical companies
Analysts predict that the inclusion will bring $10-$15 billion of inflows to China A-shares from passive and active funds benchmarked against MSCI indices in the first year. This number could rise to $40 billion annually if they are fully included in global indices, although this is expected to take at least ten years.
In order to achieve this goal, the country would have to further open its capital account, continue to make strides when it comes to curbing corruption and significantly increase foreign ownership of stocks. Calculations by Ecstrat, an investment consultancy, show that 69 of the A-shares that will be included are owned by the Chinese state either at central or local level.
For now, Nizam Hamid, ETF strategist at WisdomTree in Europe, believes that the S&P China 500 – which includes A, H and N-shares – offers investors a much more comprehensive exposure than the MSCI inclusion.
“With the MSCI Index, we are not talking about an index that is fully replicating the economy,” he adds. “If you own H-shares, you will not be missing out and will not have to buy A-shares. Also, if you are running a China fund and have exposure to the mega-caps such as Alibaba, you can add a small tail of A-shares, but it will not hugely impact performance.”
He does not foresee a host of new ETF products coming on to the market. “At the moment, we have enough products,” he says.
“If you go back two to three years, there were a number of new launches. People will be ready. I think investors are nervous about when is the right time to go in, because there is still nervousness about the macro story and political events such as North Korea.”
Mellor, at Invesco PowerShares, says that the inclusion will lead investors to think about whether to take an overweight or underweight position on China A-shares and this could trigger activity in the future.
“However, currently, the marketplace is relatively quiet and I don’t see any new ETF products,” he says. “The biggest players already have products in place that have exposure to China A-shares and in time, smaller players could look at developing them.”
Plenty to choose from
The shelves are already brimming with a variety of products, including Invesco’s PowerShares Golden Dragon China Portfolio fund based on the Nasdaq Golden Dragon China Index; State Street’s SPDR S&P China ETF; and iShare MSCI China.
Last year, WisdomTree became the first provider to launch a China ETF offering access to the full range of Chinese share classes, including those listed onshore and overseas. Deutsche Bank also debuted its db x-trackers Harvest FTSE China A-H 50 Index Ucits ETF, which attempts to overcome the price premium of A-share stocks by buying the same company via its A-share listing when it’s cheaper than its H-share listing.
Looking ahead, Marco Montanari, head of passive asset management, Asia-Pacific at Deutsche Bank, believes the China ETF market will develop over time and that in ten to 15 years, it will have the same granularity as the US and European markets.
“There will be more buckets,” he says, “but in the initial stages, providers will wait to see more interest before they introduce new products.”
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