China and the MSCI Emerging Markets Index

Mainland Chinese companies which trade in Shanghai or Shenzhen and are quoted in renminbi, known as China A shares, will be included in the MSCI Emerging Markets Index for the first time from June 2018. The move follows the success of the Shanghai-Hong Kong Stock Connect programme which was set up in 2014. This linked the Hong Kong stock market with the mainland, allowing investors in each region to buy shares on both exchanges.

China already accounts for around 30% of the MSCI Emerging Markets Index through shares listed on the China B, Hong Kong and overseas listed exchanges, quoted in either US or Hong Kong dollars. The leading companies include large technology stocks such as Alibaba, Tencent and Baidu. Historically, however, ownership of China A shares, which include a number of well-known names and market leaders, such as Petrochina and Bank of China, has been restricted to Chinese domestic investors. It is hoped that the move by MSCI will open up the market to new foreign investors and strengthen China’s position as the potential future leader of the global economy.

The changes will be modest at first. MSCI plans to add 222 China A Large Cap shares which are expected to account for only 0.7% of the overall index by August 2018 because their weighting within the index will be restricted to 5% of the current market cap of shares. Over time, it is envisaged that this restricted inclusion factor will be lifted and China A Mid Cap shares may be added too. Representation of Chinese equities could rise to around 40-50% of the MSCI Emerging Markets Index. At this stage, it is possible that Chinese equities will become an asset class in their own right in much the same way as investors currently regard European or US equities.

However, the path to this end game is unlikely to be a straight forward affair. A Shares are notoriously volatile, dominated by retail flows and speculation. Many are State Owned Enterprises too. Rising inclusion of Chinese equities depends on improving alignment with international standards. On this note, China has room for improvement. For example, following the sharp decline in Chinese equities in 2015, in a bid to achieve stability, the Chinese government banned major corporates from selling shares with malicious short sellers to be arrested.

Nearly half of all listed companies were suspended to stop further falls. Companies were directed to buy back shares to support prices with finance provided by state banks if needed.

As the Chinese market develops, we expect broader participation in the future. For fund managers, the move will open up the benchmark and widen the number of stocks which are available for investment. It is unlikely to change the way which they manage money. In the short term, it may be possible that we will see a switch from more popular areas like technology, which many emerging markets funds currently have a bias towards, into the domestically oriented sectors such as financials. Alternatively, more money may come into China, perhaps at the expense of other regions.

For exposure to China, we recommend investors take a collectives-based approach rather than an individual stock specific one. The Carmignac Portfolio Emerging Discovery Fund offers general Emerging Markets exposure with a significant weighting in China. For dedicated Asia Pacific investment, the First State Asia Pacific Leaders Fund is suitable for growth investors, although it has little in China at the current time. The Jupiter Asian Income Fund is appropriate for more defensive investors. It currently yields 3.7% and has a weighting of 7% in Chinese equities.