China: Winning the Weighting Game
Investment Manager Charlie Awdry discusses the implications of China A shares’ increased weighting in MSCI equity indices and how this is likely to attract more foreign investment in China’s equity markets.
- MSCI announced it will increase the weighting of China A shares in its indices by quadrupling the inclusion factor from 5% to 20% by November 2019.
- The decision is confirmation that the introduction of A shares into MSCI indices last year has been successful and that access is improving for foreign investors.
- Increased participation by foreign institutional investors in China’s domestic equity markets should help these markets mature, improving mutual knowledge and understanding while enabling Chinese equity issuers to improve corporate governance.
- China’s increasing importance on the global investment stage should be a strong driver for investors to reassess their exposure.
What’s the News?
Index provider MSCI announced on February 28 that it will increase the weighting of China A shares (Shanghai- and Shenzhen-listed stocks) in its indices by quadrupling the inclusion factor from 5% to 20% by November 20191.
As a result, there will be 253 large-cap and 168 mid-cap China A shares in the MSCI Emerging Markets Index, which increases the A shares’ weighting in the index from 0.7% to 3.3%. This is in addition to existing China weights in the Index from Hong Kong-listed H shares and New York-listed American Deposit Receipts. In the event of full inclusion (100% inclusion factor), China A shares alone would account for 16.3% of the MSCI Emerging Markets Index based on current market capitalizations, meaning Chinese equities as a whole would exceed 40%.
Shares listed on China’s tech-focused ChiNext, a Nasdaq-style board of the Shenzhen Stock Exchange, will also be included in the indices from May 2019.
China’s Increasing Weight within the MSCI Emerging Markets (EM) Index
Why Is It Important?
As outlined below, we expect the move to drive further positive change for China’s equities market and for Chinese companies, resulting in increased investment from global investors.
The move is confirmation that the introduction of A shares into MSCI indices last year has been positive and that access is improving for foreign investors. This is predominantly due to the successful rollout of A shares on the “Stock Connect” scheme, which facilitates mutual market access between mainland China and Hong Kong. The mechanism has proved both resilient and flexible, addressing many of the concerns that MSCI had about the alignment of the China A shares market with international market accessibility standards.
Boosting China’s Credibility
MSCI’s decision reflects broader reform in the country as the government steps up its efforts to integrate China’s capital markets into the global financial system.
The Chinese economy continues to slow, with guidance at the recent National People’s Congress targeting 6% to 6.5% gross domestic product growth, down from last year’s 6.5%. But government policymaking has taken a pro-growth turn this year, with targeted plans to boost spending, cut taxes and open up foreign investor access to its markets.
This, together with an apparent softening in the U.S. stance toward China trade tariffs, has led to a strong rally in the A shares market this year, albeit from a low base following last year’s sell-off. The rally reflects the sentiment-driven nature of the A shares market, which tends to be dominated by “emotional” domestic investors. It is this volatility that can make the A shares market particularly difficult to navigate. However, due to its sheer size and depth, it often can be a place where active managers are able to uncover opportunities.
Unlike local investors, foreign investors tend to take a longer-term, fundamentals-based approach, preferring a subset of high-quality businesses within these markets. With the increased institutional activity that the higher weighting is likely to bring, we expect some of these shares to re-rate and trade differently to the rest of the A shares market over time, with pricing inefficiencies correcting as the shareholder base becomes more stable.
Increased attention from, and participation by, foreign institutional investors in China’s domestic equity markets should help these markets mature, improving mutual knowledge and understanding while enabling Chinese equity issuers to improve corporate governance.
Diverse Opportunity Set
The A shares market is complex and dynamic. With more than 3,000 listed companies, it is one of the biggest markets in the world and continues to grow apace. Reforms are likely to translate into an even bigger number of initial public offerings over the coming years.
We believe China’s increasing importance on the global investment stage should be a strong driver for investors to reassess their exposure and consider a separate allocation to a specialist China equity manager outside their emerging markets or Asia allocation. A specialist approach to investing in China may potentially give broader and deeper exposure to dynamic Chinese companies.
1Index inclusion factor: MSCI uses the standard index inclusion factor as part of its calculations to determine the weight of a security in the index. For example, with the index inclusion factor at 20%, each A share’s weight in the index will be 20% of its available free-float market capitalization, adjusted for any applicable limits on foreign ownership.
Foreign securities are subject to currency fluctuations, political and economic uncertainty, increased volatility and lower liquidity, all of which are magnified in emerging markets. Fixed income securities are subject to interest rate, inflation, credit and default risk. As interest rates rise, bond prices usually fall, and vice versa.