Last year, MSCI — the company that constructs the indexes underlying many major ETFs and benchmarks — began to incorporate some domestically traded Chinese stocks into those indexes. These stocks, called “A shares” to distinguish them from other classes of Chinese shares that trade on exchanges outside the mainland, had been inaccessible to most global investors until the creation of a trading connection between Hong Kong and Shanghai, and expanded (but still restrictive) facilities for foreigners to trade them.
The inclusion began modestly in 2018 with MSCI’s indexes for China, Asia ex-Japan, emerging markets, and the world including A shares just for large-cap companies, and at a 5% inclusion rate — meaning that the stocks received a weight in the index based on 5% of their market capitalization. The inclusion rate is a component of the index methodology which MSCI uses to adjust the weighting of stocks from countries where a full weighting would be problematic. In the case of A shares, MSCI opted for a go-slow inclusion process because the functioning of the Hong Kong–Shanghai trading connection was uncertain, and also because of concerns about the mainland regulatory environment.
This initial inclusion obviously meant that ETFs and global investors tracking MSCI’s indexes would be buying A shares.
As expected, MSCI announced recently that it will be gradually deepening the inclusion of A shares in its relevant indexes. The timetable announced last week was slightly more aggressive than analysts had anticipated. In May, MSCI will boost the inclusion factor for large-cap A shares from 5% to 10%, and also add large-cap A shares from the ChiNext exchange at a 10% inclusion factor (ChiNext is a tech-heavy exchange analogous to the U.S. NASDAQ exchange.) In August, A-share large caps will go from 10% to 15%. And in November, the A-shares large cap inclusion factor will go from 15% to 20%; ChiNext large caps will go to 20%; and A-share and ChiNext mid-caps will also be added at a 20% inclusion factor.
After the November boost, A shares traded on both the Shanghai and ChiNext exchanges will go from 2.5% to 10.4% of the weight of MSCI’s China index, and will also increase their weighting in MSCI’s Asia-ex-Japan index, emerging-markets index, and all-world index.
Source: Goldman Sachs Portfolio Strategy Research
As the chart above suggests, the rise to a 20% inclusion factor is not the end of the road; MSCI could decide to include mainland-traded Chinese shares at a 100% inclusion factor. That would result in domestic Chinese shares comprising 14.6% of its emerging-market index, versus 0.8% currently.
MSCI noted in its press release what the obvious obstacles are for domestic Chinese shares receiving a full weighting in its indexes:
“… a future weight increase of China A shares in the MSCI Indexes beyond 20% would require Chinese authorities to address a number of remaining market accessibility questions. MSCI is in contact with the appropriate regulatory authorities to discuss the highlighted market accessibility constraints, including restrictions on access to hedging and derivatives instruments as well as concerns regarding the short settlement cycle of China A shares, the trading holidays of Stock Connect [the Hong Kong–Shanghai trading connection] and the availability of an Omnibus trading mechanism. MSCI welcomes the progress Chinese authorities have made thus far to improve the accessibility of the China A shares market and their plans to actively promote the further opening and development of that market.”
In other words, politely stated, there remains work to do.
Still, the current increase to a 20% inclusion factor will mean about $70 billion in total index-related inflows into the domestic Chinese market through November 2019. Emerging-market funds will need to target a 3.3% weighting to A-shares, and Asia-ex-Japan funds a 4% weighting.
EM = emerging markets; AeJ = Asia excluding Japan
Source: Goldman Sachs Portfolio Strategy Research
Investment implications: We are bullish on China. We recognize that the Chinese domestic market is largely driven by the sentiment of retail investors rather than overall economic fundamentals. Nevertheless, like other markets, it is a discounting mechanism, and market participants have begun to price in a turn in the deceleration of Chinese growth as that growth is sparked in the second half of 2019 by increasingly aggressive stimulus measures from the central government. The broadening inclusion of mainland Chinese shares will be a further boost to sentiment. Non-China-based investors have a variety of ETFs available for exposure to mainland Chinese shares.
