China A-shares: What Emerging Market Equity Investors Need to Know
- China is set to become a larger piece of the MSCI Emerging Markets Index with the introduction of A-shares
- A-shares are relatively liquid compared to other Chinese stocks and will bring better sector diversity to the index’s China position
- A-shares can be volatile and the index is set to be more heavily concentrated in Chinese shares
What Are China A-Shares?
China is set to become a much larger piece of the MSCI Emerging Market (EM) Index, as MSCI plans to add securities known as A-shares from China’s large cap companies to the Index this year. This change could be both positive and negative for index investors, and helps demonstrate a rationale for active management in emerging markets.
In June 2017, MSCI said that it was set to introduce 235 of the almost 3,500 companies in the A-share class as part of an initial inclusion in the MSCI EM index. A-shares are shares of Chinese companies and were until recently only available for purchase by Chinese citizens. Since 2003, some foreign institutions have been allowed to purchase A-shares through a system known as the Qualified Foreign Institutional Investor (QFII) group. Until recently, A-shares have not been more widely available to investors.
A-shares’ Share of the Index
The 2018 launch of A-shares in the index will take place in two phases, the first in May and the second in August.
In total, the A-shares are set to comprise an initial 0.73% position in the index. Over time, however, it is likely that the position of China A-shares in the index will grow, particularly as foreign ownership limits are lifted and as concerns over trade settlements and suspensions are addressed. If they are addressed, experts think that China’s total position in the index could grow to more than 40%, and a large portion of this would be A-shares.
What Are the Benefits and Risks of China A-share Exposure for Emerging Market Index Investors?
On the positive side, adding A-shares means adding more liquid shares to the index’s China exposure. China’s A-share market comprises many major large cap companies. These include financial giants like Bank of China and Ping An Insurance, as well as well-known names like Tsingtao Brewery and SAIC Motor. These are some of the most highly traded companies on the Chinese market. In addition, adding these names gives investors exposure that is more diverse to the Chinese market.
Sector diversity among A-shares is much greater than it is in the local market that international investors had the most access to previously. Index investors will now have a far more comprehensive exposure to major companies in China’s steadily growing economy.
Of course, A-shares are not without risks. First, A-shares have historically had a predominantly retail investor base. This means they can be volatile, because retail investors often pull their money faster than institutional investors do.
In addition, corporate governance of some of these large Chinese firms is an ongoing issue for investors. In particular, the A-shares market includes many large state-owned companies, such as banks and oil companies. These are now likely to be included in the index. Inefficiencies and even fraud can be widespread in such firms. Until now, Chinese state-owned companies have not been subject to as much outside scrutiny from foreign investors that could pressure them to make changes in these areas.
Transparency in China’s markets is improving, but trading suspensions abound. In China, suspensions of trading in a company’s shares can occur for several reasons. These include irregular trading or attempting to avoid large price movements at times of high volatility. While liquidity in A-shares is known to be high, such frequent trading suspensions may make investors fear that liquidity may not be so strong.
Further, the introduction of A-shares may make country concentration a bigger issue for investors. If China reaches near 40% of the index as predicted, that would be substantial exposure to one country for investors. Currently, the BRIC countries (Brazil, Russia, India and China) as well as South Korea and Taiwan, dominate the index. However, several of these countries, like Brazil and Russia, are not growing as fast as some other EM nations.
Active Managers May Find an Opportunity to Add Value in EM Strategies
An active manager can choose among countries and sectors to find the best opportunities for growth and return. Importantly, an active manager can also choose to invest in better, governed firms in countries with market infrastructure that is liquid and functions well. Index investors can benefit from low costs, and the introduction of China A-shares will give index investors broader and more diverse exposure to Chinese companies.
However, the risks of the A-shares demonstrate active management’s advantages here. As always, the choice of an active or passive approach depends upon many factors. These include individual investor circumstances and preferences, but the introduction of more A-Shares should provide additional opportunities for stock-picking, emerging market managers to add value or, in some cases, not.
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