Mark Williams

MSCI A Share inclusion - symbolic rather than significant

Mark Williams

MSCI’s inclusion of China A Shares(1) in its indices is symbolic but not immediately significant. The short-term impact on indices will be minimal. We currently hold no A Shares within the Fund, as we believe we can find better opportunities elsewhere. However, we expect this mainland market to become more representative of fundamentals in the future, which would increase the chance of us finding more attractive investments there.

The Chinese A Share market by many measures is one the biggest in the world. The two mainland exchanges for A Shares, Shanghai and Shenzhen, have market capitalisations of US$5.1tn and US$3.1tn respectively (source: World Federation of Exchanges, 2017). This puts the country on a par with the world’s larger exchanges. In Asia, the Japanese exchange alone is slightly bigger (US$6.2tn); Euronext, the largest exchange in continental Europe (US$4.4tn), is smaller than Shanghai; making the US exchanges the only ones with significantly greater scale (the NYSE and NASDAQ have respective market caps of US$22tn and US$10tn).

Until now, however, it has been absent from the most prominent equity indices. This is why MSCI’s decision to add China A Share to its indices has garnered such attention. An index review released overnight gives details of the A shares which will be included from 1 June. 

Partial inclusion restricts immediate impact on indices. These A Shares will initially only be added at 2.5% of their potential full weight, moving up to 5% at the next quarterly index change on 1 September. This ‘partial inclusion’ approach means that the changes to MSCI indices will initially be negligible. In June of last year, MSCI estimated that A Shares – following the September 2018 increase – would only account for 0.1% of the MSCI AC World Index (other Chinese equities make up 3% of that index); 0.8% of the MSCI Asia ex-Japan Index (China’s weighting there is 33%) and 0.7% of the MSCI Emerging Markets Index (v 29% for other Chinese equities). 

Mark Williams: MSCI A Share inclusion - symbolic rather than significant

Accessibility improvements will, in time, drive greater prominence for the A Share market. It was not until the fourth time of asking, at the June 2017 index consultation, that the MSCI confirmed China A Shares would be added. At three previous consultations, the proposal had been rejected. That the fourth review saw a different outcome was due to the MSCI’s assessment that there had been “ongoing improvements in China’s market accessibility conditions”. 

One of the main improvements to accessibility over recent years has been the introduction and growth of Stock Connects allowing investors in Hong Kong to buy mainland A Shares and the corresponding purchase of Hong Kong listed companies by those on the mainland. 

As further accessibility improvements are made, the A Share inclusion factor is likely to be increased.  There are currently two Connects with mainland China, Shanghai-HK and Shenzhen-HK, and there has been a proposal for a Shanghai-London Connect to be opened later this year.  In addition, foreign investors can access A Shares via routes such as a RQFII (Renminbi Qualified Foreign Institutional Investor) licence. 

We are likely to see accessibility increase further. If the MSCI increased the A Share inclusion factor to 100% and also included mid-cap A Shares, then the China A Shares could account for around 17% of the MSCI Emerging Market index, with the China total at almost 41%.

Mark Williams: MSCI A Share inclusion - symbolic rather than significant
 
Such a prominence of A Shares within MSCI indices would clearly be significant, both for passive investors looking to replicate them and active investors such as ourselves who seek to outperform them. 

For our fund we are targeting companies with a combination of dividends, growth and attractive valuations, and we currently find more opportunities with these three factors outside the A Share market, often due to the expensive valuations of domestic Chinese equities.
  The Shanghai Composite and Shenzhen Composite trade on prospective price/earnings ratios of 12x and 20x respectively. In the Liontrust Asia Income Fund we currently invest in Hong Kong listed shares of Chinese companies with our exposure trading on an aggregate PE of 11x, less than the Hong Kong listed companies index and also less than the A Shares.

A good illustration of the high valuations of Chinese A Shares is the Hang Seng China AH Premium Index, below. This measures the share price premium or discount of A Shares over H Shares for some of the largest China companies with both A Share and H Share listings.

Mark Williams: MSCI A Share inclusion - symbolic rather than significant

As the chart shows, A Shares currently trade at a premium of over 20% to their corresponding H Shares. Although there are a number of companies that have listings in both markets, equities in one company cannot be transferred between markets and so there is no scope to arbitrage significant price differences.

Part of the reason for the lofty valuations of A Shares is that you have a group of domestic Chinese savers who have few alternatives in which to invest their money, despite the improving access to Hong Kong via the Connects. Bloomberg estimates that individual retail investors account for 80% of trading volume in mainland China. We believe that this increases the influence of investor sentiment compared to fundamentals in the market.

As international market exposure increases, we believe that the fundamentals will become more assertive, and we stand ready to enter the market as and when opportunities appear.
Key in this process will be the accessibility improvements being made to China’s mainland exchanges, which themselves must be viewed hand-in-hand with China’s wider economic transition. A narrowing of the A Share / H Share premium would be one signal that domestic investor sentiment is having a lesser influence on stock movements. 

As with so much in China’s economic rebalancing and development it can be a case of ‘two steps forward, one step back’ and it is no different here. At the same time as improving capital mobility between mainland and offshore exchanges, China has been guilty in the past of intervening in its mainland markets, and allowing swathes of the market to be suspended, in an attempt to manage them through periods of volatility. Risks like these must be factored into investment decisions. 

Our investment approach is built around the analysis of the key investment drivers for Asian equities and the identification of companies with exposure to these drivers that offer an attractively valued combination of earnings growth and divided yield. The A share market is part of the investment universe we consider. Were our investment process to highlight any of these companies as attractive investments, then we would invest. In the meantime, we are in no hurry to dive in. If we screen the global equity universe for liquid stocks offering earnings growth (10%+) and dividend yield (3%+) we find that a third of them are to be found in Asia Pacific ex-Japan, excluding A Shares. The A Share market may be massive, but the Asian investment universe is already a fertile hunting ground for investors looking for income and growth. 

(1) A Shares are company shares that are traded on China’s mainland stock exchanges in Shanghai and Shenzhen. H Shares are shares in Chinese companies that are traded on the Hong Kong Stock Sxchange.

For a comprehensive list of common financial words and terms, see our glossary here.


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Tuesday, May 15, 2018, 11:26 AM