A-SHARES: Waiting for the index maker

As China opens up its capital markets, investors are waiting for index compiler MSCI to respond by including Chinese A-shares in its Emerging Markets index. But when will that happen? George Mitton reports.

With an estimated $9 trillion (€7.2 trillion) benchmarked against its indices, MSCI’s decisions are watched carefully by almost all investors. If MSCI decides to add a country to one of its popular indices, such as Emerging Markets, the country can experience rapid and substantial inflows from fund managers and institutional investors who care about matching their benchmarks.

Stock prices generally shoot up in response to an upgrade. In the 11 months between MSCI announcing the United Arab Emirates would be reclassified as an emerging market and it being implemented in May 2014, stock prices on the Dubai Financial Market more than doubled. Large gains were also recorded in the UAE’s other main exchange, in Abu Dhabi, and in Qatar, which also gained an upgrade.

It is natural, then, for investors to wonder when MSCI will include Chinese A-shares in its Emerging Markets index. As new initiatives such as the Shanghai-Hong Kong Stock Connect make it easier for international investors to access China A-shares, hurdles to their inclusion appear to be lowering every passing month. How soon will it happen and how can fund managers best position themselves to benefit?

Most asset managers agree that the launch of Stock Connect is positive – and could lead to improved inflows to their funds.

“The percentage of Chinese stocks in MSCI indices is always discounted because of [the] difficulties in accessing [such stocks in] the market,” says Tino Moorrees, chief executive at BNP Paribas Investment Partners Hong Kong. “Stock Connect might trigger MSCI to raise the percentage of China, which will create a lot of demand from institutional investors. We want to be there to capture that opportunity.”

Certainly, the A-shares market is appealing to international investors. Stock Connect gives foreign investors access to 568 onshore listed companies through selected Hong Kong brokers. Importantly, many of these firms are in exciting, domestic-focused sectors such as healthcare, consumer spending and technology. (In contrast, the Hong Kong stock exchange is four-fifths financial and energy companies.)

In addition, the Chinese market looks cheap on some measures. The MSCI China index, which comprises roughly 52% A-shares, was trading at just over 10 times price-to-earnings at the end of November, compared with more than 13 times for the wider Emerging Markets index.

So, will MSCI respond to Stock Connect by adding Chinese A-shares to the MSCI index? Not necessarily, says Chin Ping Chia, head of MSCI index research in Asia. One concern is that, after the first day of trading, investment flows in the Stock Connect scheme have been below capacity. “That reflects hesitation in the markets,” he says.

The level of flows is important because MSCI’s role is to respond to the needs of investors. All its decisions about inclusion or rejection from its indices are taken in consultation with its clients, which are large institutional investors from around the world. If these investors are not taking advantage of a new initiative such as Stock Connect, that will make MSCI cautious.

In this case, such wariness is well founded. One concern is the unique custody arrangements in the Stock Connect scheme, a result of the imperfect meshing of two different regulatory systems in Hong Kong and Shanghai. Many investors are uncertain how the Chinese regulators will recognise nominee and ownership concepts, should they ever be tested. As a result, some investors are taking a wait-and-see approach.

Another result of the slightly awkward interface between the different regulatory schemes is the problem of pre-delivery. Many investors do not want to pre-deliver, as is required in the current set-up of Stock Connect, because it exposes them to counterparty risk. This is an issue that investors do not encounter under the qualified foreign institutional investors (QFII) or the RQFII schemes, which may prompt some to stay with their existing arrangements for the time being.

Of course, QFII and RQFII both have their limitations too. For the QFII scheme, the main hurdle is that licences are awarded on a case-by-case basis and are capped, meaning institutional investors may not have the freedom to invest as much in the Chinese market as they wish. 

The RQFII scheme, which allows foreign investors to buy Chinese A-shares using offshore renminbi, is more permissive but still includes caps at each entry point. The RQFII quota of Hong Kong, which has the largest demand for Chinese stocks, is almost used up. The Chinese authorities have recently expanded the RQFII programme, awarding quotas to new cities such as Toronto and Doha. But there are still some notable absences from the programme – there is currently no RQFII quota for the US, for instance.

“With the development today we need to look at whether investors are actually taking advantage of the schemes,” says Chia. “Investors continue to get QFII quotas and that indicates a market demand. Obviously, Stock Connect is providing some liquidity. But, overall, you need to get to a stage where the investor feels comfortable.”

He adds: “Investors probably only need one scheme that provides full access, whether that is QFII, RQFII or Connect. Connect is probably the most promising channel today. It’s more market driven and there is no distribution issue. The hurdle in front of Connect is smaller.”

Clearly it will take time for investors to become comfortable with Stock Connect, as regulators iron out some of the problems with the initiative. One issue that foreign investors face when using the scheme is that investment in A-shares in Shanghai is subject to withholding and capital gains taxes. In addition, there is currently no intraday trading. 

“Relative to the rules in Hong Kong, investors will have to endure more restrictive trading regulations in Shanghai,” says Darius McDermott, managing director of Chelsea Financial Services. “Retail investors should be very aware of all of the potential risks around regulatory issues and tax implications before investing in any markets.”

Another aspect that will need to be resolved is the problem of imbalanced flows. So far, northbound trade – that is investment flows moving from Hong Kong to Shanghai – has outpaced southbound. This indicates there is more demand from foreign investors to access China than for Chinese investors to buy stocks in Hong Kong. This is, perhaps, understandable. Many Hong Kong-listed stocks are in fact dual listings of Chinese firms that mainland investors can already buy. (There are some exceptions, notably in the internet sector.)

For the Stock Connect scheme to succeed in the long run, the problem of asymmetric flows will need to be fixed somehow. This may take time, especially if China continues to grow at a fast pace and gives domestic investors a range of attractive investment options at home. With bank deposits in China yielding better returns than investments in some developed equity markets, it is understandable if some Chinese investors exhibit a home bias, especially because investing domestically allows them to keep their money stored in renminbi, which is widely expected to appreciate in the coming years.

“We probably need the intersection of China doing poorly and the rest of the world doing well,” says Blair Pickerell, Asian chairman of Nikko Asset Management. “Then there would no longer be this feeling of, ‘Why invest abroad’ from the world’s fastest growing nation.”

These are the issues MSCI will consider in its review. Chia says this process is ongoing, and the firm has committed to reveal the results of the current review by June 2015. Based on the firm’s experience with other upgrades in the past, an upgrade would be implemented a year after MSCI made the announcement, meaning the earliest Chinese A-shares could enter the MSCI Emerging Markets index would be mid-2016. 

This could well happen, but is by no means guaranteed. Much will depend on take-up of the Stock Connect programme in the next six months.

©2015 funds europe



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