Answers to our clients’ questions about market action and the market environment in a few paragraphs every two weeks.
No, MSCI index inclusion will not trigger a bull market in Chinese A-shares.* Given the very modest initial weights and the lack of clarity on future increases, we doubt that index-driven flows will drive share prices meaningfully higher. Thus, we do not recommend that investors use MSCI’s inclusion as the driver of any decision on whether to overweight this market.
As a recap, MSCI announced last summer that A-shares will be included in the MSCI China, Emerging Markets (EM), and All Country World (ACWI) indexes beginning in June 2018. Given lingering concerns by market participants over access and the ability to effectively replicate the global indexes, MSCI is only applying 5% of the free-float market capitalization of Chinese A-share companies in determining their index weight. Further, the 5% inclusion framework is being phased in, starting at 2.5% on June 1 and increasing to 5% on September 3.
Based on MSCI’s eligibility criteria, only 234 A-share stocks (out of a universe of 3,000+) will be added to the MSCI China Index and other indexes this year. Given the 5% inclusion threshold, this will add only US$47 billion in free float–adjusted market cap by September, which translates to only 2.8% of the MSCI China Index, 0.8% of the MSCI EM index and 0.1% of the ACWI. Furthermore, actual index-related inflows into A-shares may be only in the neighborhood of US$22 billion, based on the roughly US$14 trillion of assets benchmarked to MSCI indexes. Considering these relatively small weights, the inclusion of A-shares into the MSCI indexes is (by design) not a major shift in index exposures, nor should it trigger large inflows into A-shares on its own.
However, should MSCI decide at some point to lift the inclusion threshold beyond the current level, the inclusion of A-shares will have a large impact on global indexes. For instance, MSCI estimates that A-shares could potentially compose approximately 40% of the MSCI China Index, taking China’s weight in the MSCI EM Index to about 42% and China’s weight in ACWI to 6%. This would result in large index-related flows into A-shares, and potentially higher prices. However, if this were to happen, it would likely take several years.
It is worth pointing out the impact the inclusion of A-shares could eventually have on the MSCI China Index. Specifically, the A-share market is overweight sectors such as financials (33.6%) and industrials (13.5%), while underweight IT (8.5%). Thus, the inclusion of A-shares will increase exposure to “old China” in the form of the financial-industrial-commodity complex and reduce the “new China” IT exposure that has been a key driver of China’s recent growth.
Given all of the above, a natural question is whether now is a good time to increase exposure to A-shares. Our general take is that valuations are below their historical average levels, making now not a bad time to increase exposure. A-shares have lagged behind offshore equities, with the MSCI China A Onshore Index returning -10.1% year-to-date through May 31 in local currency terms. Poor performance has been driven by the lack of exposure to tech in the A-share universe, concerns over a US-China trade war, and the ongoing crackdown on financial leverage in China. Monetary policy has been a key driver of the A-share market in the past, with easing cycles being a key catalyst for A-share rallies, and vice versa.
Though starting to look attractive, this is not necessarily a pound-the-table opportunity requiring an A-share-only mandate. Indeed, rather than taking a specific bet on A-shares (especially as a passive beta play), we still think investors are better served by taking an “all China” approach—choosing active managers with the flexibility to allocate to onshore and offshore equities as they deem fit, either based on relative valuations or stock-specific opportunities.
The distinction between A-shares and offshore Chinese equities has become blurred because of the Stock Connect program, which allows offshore investors to purchase A-shares via the Hong Kong stock exchange. Eventually, this distinction will disappear. With the MSCI benchmarks slowly moving in that direction, we think investors should give their managers the widest opportunity set.
* A-shares refer to Chinese companies listed in Shanghai and Shenzhen, as opposed to the Chinese companies listed offshore (primarily Hong Kong and the United States) that currently make up the MSCI China Index.
Aaron Costello is a Managing Director on Cambridge Associates’ Global Investment Research Team.
Originally published on June 5, 2018 This report is provided for informational purposes only. The information presented is not intended to be investment advice. Any references to specific investments are for illustrative purposes only. The information herein does not constitute a personal recommendation or take into account the particular investment objectives, financial situations, or needs of individual clients. This research is not an offer to sell or the solicitation of an offer to buy any security in any jurisdiction. Some of the data contained herein or on which the research is based is current public information that CA considers reliable, but CA does not represent it as accurate or complete, and it should not be relied on as such. Nothing contained in this report should be construed as the provision of tax or legal advice. Past performance is not indicative of future performance. Broad-based securities indexes are unmanaged and are not subject to fees and expenses typically associated with managed accounts or investment funds. Investments cannot be made directly in an index. Any information or opinions provided in this report are as of the date of the report, and CA is under no obligation to update the information or communicate that any updates have been made. Information contained herein may have been provided by third parties, including investment firms providing information on returns and assets under management, and may not have been independently verified.