China set to outgrow EM indices

Asset Class in Focus

Chinese equites should be treated as a separate investment “sleeve” as their weighting within EM indices approaches 50%, according to JP Morgan Asset Management.

Early in 2019, MSCI announced that in November 2019, it will raise the inclusion factor for China A-shares in its benchmark emerging markets index to 20% (of the market capitalisation of each individual stock).

“It would be hard to exaggerate the importance of this latest development, which will have added 421 Chinese stocks to an 830-stock emerging markets index in a span of 18 months,” according to a recent JP Morgan Asset Management report.

JPMAM estimates that the November rise in the inclusion factor to 20% will give China’s domestic stocks a weighting of 3%-4% of the MSCI EM index by the end of this year.

This is expected to rise to 15% over time, and when offshore-listed (in Hong Kong and the US, for example) China stocks are added, the Chinese proportion of the EM index will amount to 50%.

Inclusion concerns

It was only in 2018 when MSCI finally included China A-shares in its emerging market equity indices. Perhaps still not free of its reservations that led it to reject any inclusion for three successive years, the MSCI plan was a gradual one. It started with large cap stocks and an inclusion factor of only 5% (full inclusion, enjoyed by most countries’ markets, is 100%).

The 2018 decision had been announced a year earlier. The index provider was waiting until China addressed investor concerns such as uncertainty of capital gains tax, questionable beneficial ownership under the early phase of the Stock Connect programme, widespread voluntary stock suspensions and pre-approval restrictions on launching financial products.

An important precedent to inclusion was the December 2016 expansion of the Stock Connect to include Shenzhen-traded shares. It provided investors access to China’s “new economy” companies that foreign investors were keen to gain exposure to.

A-shares vs offshore China stocks

Alexander Treves, investment specialist for emerging markets Asia Pacific equities at the firm, told FSA that the A-share component will likely soon make up a bigger proportion than offshore-listed counterparts because they are typically companies that will service the “upgrading consumption preferences” of China’s expanding middle class.

He highlights healthcare, technology, leisure and entertainment, tourism, food and beverages and household goods sectors, which are “well-represented in the A-share market”.

In contrast, offshore-listed Chinese companies, which have been accessible to foreign investors for at least two decades, are mainly large state-owned banks, oil & gas, telecom and utility companies.

However, investors with passive index exposure will have to wait for the phased inclusion to play out. That could mean getting only limited exposure to some of the highest growth areas of the Chinese economy.

“Given our view of their quality, and of the structural growth underlying many of these stocks [through Shanghai-Hong Kong Stock Connect since 2014], we believe it makes sense to gain exposure early rather than waiting for the index to catch up over time,” said Treves.

Therefore, the case for investing with a separate China sleeve, rather than within an EM allocation is compelling, according to Treves.

Investors should approach asset managers who offer pooled vehicles or segregated accounts for their China allocations, he said.

Managers with dedicated, on-the-ground resources and broad coverage of the market may be best positioned to identify the companies most likely to generate strong returns for investors, according to Treves.

“Conversely, gaining exposure through a traditional market cap-weighted index or ETF will result in exposure dominated by the largest stocks, some of which represent China’s state-owned past rather its consumer- and innovation-led future.”

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