Emerging Markets ETFs May Soon Take Higher Exposure To Mainland China 1
The light trails on the modern building background in china.

MSCI’s decision regarding the inclusion of Chinese domestic A-share securities into the MSCI Emerging Market index series is around the corner. Whether or not the inclusion is coming, it is a good time to look beyond the announcement and to better understand the dynamic currently at work and the potential implications for portfolio management and the industry. 

MSCI’s Impossible Trinity

Leveraging on the annual consultation process, MSCI Inc. has been successful in managing their clients’ potentially divergent expectations, their relationship with the Chinese regulators and their ambitions on the mainland as a commercial entity.

In the wake of the negative decision communicated last year, the Chinese Securities and Regulatory Commission (CSRC) and MSCI have launched a dedicated working group to address the outstanding issues flagged by MSCI. CSRC’s top officials are active participants to this working group highlighting the importance for China to deliver on that front. If CSRC officials were more concerned by domestic market volatility in the second half of 2015, it seems that a number of key steps forward have been materialising over the last couple of weeks, boding well for a positive decision on the inclusion.

The primary concerns of MSCI’s clients are related to capital mobility and this is mainly reflecting the industry’s largest active and passive asset managers’ views. The newly implemented accessibility enhancement policies targeting the quota allocation process (QFII, RQFII) and major easing observed in terms of capital mobility restrictions (QFII/RQFII/Stock Connect) should ease these concerns, as MSCI representatives demonstrated when we last saw them in April 2016.

Besides, CSRC’s Chairman Liu Shiyu and Chinese Premier Li Keqiang confirmed in March 2016 the launch of Shenzhen Hong Kong Stock Connect this year. As HK Exchange CEO Charles Li clearly expressed when we met with him in Hong Kong recently, Shenzhen-Hong Kong is a “done deal” and should be announced in the coming weeks for a start of the trading under this new access channel within three months.

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Following the recent clarification by the CSRC of the beneficial ownership issue between nominal holders and QFII/RQFII and the announcement of further clarifications by the Stock Exchanges on suspension policy, only the anti-competitive measures imposed by the local Chinese stock exchanges which limit the fund vehicles available to international investors remains an important issue that could jeopardize a positive decision on the inclusion.

CSRC is ready to move forward and this is when MSCI Inc. will also consider its own interest as a commercial corporation. Today, a little bit less than 20% of their revenues comes from passive investment, where the “wait and see” approach prevails. The critical issues have been dealt with under the close collaboration with the Chinese regulator.

The Chinese A-share market represented in 2015 up to 30% of global cash equity transactions and there is more to come. China’s assets under management reached Rmb7.8trn (US$1.2trn) as of May 2016 and more than 2/3rd is coming from professional institutions (asset managers on behalf of institutional investors, pension funds, insurance companies etc.). So far, the bulk of the investment remains focused on onshore opportunities, the net asset value of offshore Chinese mutual funds representing less than 1% of the assets under management. Professional institutions are only starting to seize international opportunities and MSCI Inc. is clearly positioning itself as the privileged partner to accompany them on this journey to the West. 

So far, the odds for a positive decision regarding the inclusion of A-shares in the MSCI Emerging Market Index series should be above 50%. 

A Wake-Up Call For Asset Managers and the Industry

Beyond the announcement, whether the decision is positive or not, it is critical to recognize that the inclusion process has been started and will not stop. If the partial inclusion proposal is accepted, the number of constituents in the MSCI China Index would increase from 157 to more than 600 within 12 months. The majority of new constituents will come from A-shares. The MSCI EM Index is not immune from this paradigm shift. Even with an inclusion factor at 5%, more than 400 A-share constituents will be eligible in the new index format.

China A Shares

The announcement of the launch of the Shenzhen Hong Kong Stock Connect further leveraged by the MSCI decision should definitively improve the momentum for Chinese equities. Through the first weeks in that process, the main beneficiaries will most likely be offshore small and mid cap companies. Valuation difference between Chinese small and mid cap listed in Hong Kong versus their domestic counterparts on Shenzhen and Chinext markets, early positioning of Chinese domestic investors into these offshore names, lack of insight by foreign asset on onshore small cap should all contribute and support this initial market reaction.

The wake-up call for the industry will come post the initial catch up of Chinese markets. Onboarding more than 400 new securities in an investment universe is not an easy task. It creates multiple challenges due to the lack of stability in fundamental quantitative signals on the domestic Chinese market. The implications in terms of the stability of investment process are significant and the ability of the fund manager to continue to deliver above peers performance will be challenged. Barriers to entry will not come anymore from the access to a QFII/RQFII pool but rather from the existence of a track record on a combined onshore and offshore Chinese universe.

5 years down the road and with a potential full inclusion of A-shares, China could represent up to 41% of the MSCI Emerging Market Index considering today’s composition. The question will then be not if, but when China should reach the “stand alone” country index status, on par with Japan, Europe or the US in asset allocation decision.

In that process, structural themes shaping the future of China will stand out. They are all related to the “new China” investment opportunities and environmental protection is one of them. This strategy can typically deliver above average return versus the market. With more than 300 names listed onshore in Shanghai and Shenzhen or offshore in Hong Kong and in the US, this investment universe offers an unraveled field of investment opportunities ranging from arbitrage strategies to domestic champions’ capability recognition.

The impossible trinity is coming to an end and the process has started. The MSCI decision should not come as a surprise. The train is leaving the station.

The author is François Perrin,  Portfolio Manager for Greater China for East Capital.

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