On 20 June 2017, MSCI announced that with effect from June 2018, 222 China A-share large cap stocks will be included in the MSCI Emerging Markets and All Country World (ACWI) indices through a two stage process. This represents a milestone in the evolution of China’s domestic equity capital markets, the second largest in the world by market capitalisation.
It gives recognition to the significant progress by the Chinese authorities in the opening of their markets to foreign investors, especially through the Hong Kong and Shanghai/Shenzhen Stock Connect schemes("Connect Schemes").
This event may be easily dismissed in the short term. The initial impact on indices is likely to be small due to MSCI’s phased approach to inclusion. For example, China A-shares will represent just 0.73% of the MSCI Emerging Markets Index in 2018, due to MSCI’s partial inclusion factor of 5%.1
But based on over 15 years’ experience investing in Chinese and broader Asian markets, including the China A-share market, we believe dismissing the importance of this event would ignore a number of important features and benefits of the market that A-shares can bring to global and regional portfolios.
MSCI is a leading global index provider. Approximately $1.6 trillion of active and passive assets under management follow the MSCI Emerging Markets Index, while nearly $3 trillion follow MSCI ACWI benchmarks.2
China A-shares are going to be something that allocators of capital can no longer ignore.
Inefficiencies in onshore market can create value
The China A-share market is highly inefficient due to the greater presence of retail investors. They make up over 80% of the daily turnover of the market and often make behavioural errors when investing, such as herding. Foreign institutional investors only hold around 1.5% of the market. This represents a unique opportunity for a disciplined bottom-up process, such as our 4Factor™ process, to find great quality companies on reasonable valuations. Retail investors tend to perceive these companies as ‘too boring’, in their herd-like quest to own the next big growth stock. This stands in contrast to global markets where investors have to pay a premium for quality stocks.
China A-shares can add growth and quality at a reasonable price as the market is inefficient.
A-shares represent an exciting avenue for global investors to participate in the next stage of China’s growth dynamic. Although the MSCI has included only 222 companies, investors can access almost 1500 companies under the Connect Schemes, particularly in fast-growing segments of the market such as consumer durables, automobiles, leisure and entertainment, consumer staples, pharmaceutical and technology sectors.3
Larger investment universes represent a greater opportunity to add alpha in portfolios.
In the long term, A-shares have tended to exhibit greater volatility than developed markets, but correlations are significantly lower. For example, in the last five years the Shanghai and Shenzhen markets have a correlation co-efficient of approximately 0.23-0.25 to the MSCI ACWI Index versus 0.90 for the MSCI Europe Index. Of course these benefits will diminish over time as China’s capital markets open up.4
In the meantime global investors can benefit from diversification efficiencies.
We believe that eventually China will achieve full inclusion e.g. 100% weighting. When it does so, China will represent a very large component of the MSCI Emerging Market index (some 37% on our estimates) and will become a unique asset class in its own right.
We believe we are well placed to advantage of this trend and that our 4Factor™ philosophy is ideally suited to this large exceptional asset class. We aim to find good quality companies that are cheaply valued, with improving profitability and that the market’s behaviour is anchored in its reluctance to believe this change, while the share price is in a positive uptrend. This process, alongside a talented team of investment professionals, has driven our exemplary long-term track record in All China, Asia and emerging market equities.
We believe this may prompt asset allocators to pick dedicated specialist managers who have a demonstrable track record in this area.
1 Source: MSCI
2 Source: Goldman Sachs estimates, 1 June 2017.
3 Source: HKSE, June 2017
4 Source: Bloomberg, June 2017
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