An Emerging Markets Shakeup

By: Richard A. Anderson

China is one of the fastest growing economies in the world and is home to some of the best-in-class businesses, particularly in the technology industry. However, most investors domiciled outside of China have had limited access to these Chinese companies. China’s capital markets are not fully open to foreign investors because the Chinese government does not allow the free flow of capital into or out of mainland China.

To further compound the matter, the Chinese government may be a substantial shareholder of certain companies, so a large quantity of the company’s stock may not be available for trading. Even though China has made meaningful progress in opening its economy and financial markets, the complexities of capital restrictions and government ownership have hampered foreign investment. Research has shown that government-owned companies are not always run for the benefit of shareholders, which negatively affects shareholder returns.

Until recently, foreign investors could only invest in Chinese companies that trade on the Hong Kong or U.S. stock exchanges, which is only a fraction of the Chinese investment universe. The vast majority of Chinese publicly traded companies are listed on the Shanghai and Shenzhen stock exchanges and are known as “A-shares.”

Investment in A-shares by foreign investors has been limited to a select number of qualified institutions. As a result, Chinese stocks represent only about 3% of global equity benchmarks, even though they comprise about 15% of global equity market capitalization.

On Friday, index provider MSCI took a major step to reduce the underinvestment in Chinese companies. MSCI added more than 230 Chinese stocks, known as A-shares, to its Emerging Market and All Country World indices. This move comes after a lengthy review process by MSCI.

In order to limit short-term market impact, MSCI will split the initial investment in China’s A-shares into two phases. After the two phases are completed in September, A-shares will represent about 0.8% of the MSCI Emerging Markets Index. It should be noted that if the Chinese A-shares were fully incorporated today, they would represent over 17% of the MSCI Emerging Markets Index. The timing of full inclusion remains uncertain, but MSCI has made it clear it will seek to limit the market impact of any move.

Although the representation of A-shares at this moment is minimal, this is a monumental move for emerging markets investors and Chinese businesses. It serves as a symbol of the trend toward Chinese stock market inclusion. It will also allow most investors the opportunity to access a growing market, and Chinese companies the opportunity to access new sources of capital.

The move by MSCI highlights one of the drawbacks of index investing. While we believe index investing is an improvement over active management, one of the shortfalls is that a commercial index provider, in this case MSCI, determines which securities are held and when they are traded. Any index fund with a mandate to track the MSCI indices that include Chinese A-shares were forced to buy these companies on Friday.  

At HIGHLAND, we believe in an alternate approach that structures portfolios along the dimensions of expected returns and adds value through efficient trading and implementation. Our preferred investment manager, Dimensional Fund Advisors, does not rely on benchmark inclusion to determine either country or stock eligibility. As such, Dimensional has made the decision not to include China A-shares in its emerging markets strategies.

Because the A-share market is not fully open to foreign investors, it is mainly driven by local Chinese investors who do not have full access to the capital markets outside of mainland China. This means expected risks and returns in this market are not commensurate because local Chinese investors are limited in their investing opportunity set.

In addition, investing in A-shares comes with other challenges relating to implementation and availability of real-time information. The portfolio management and trading teams at Dimensional will continue to monitor this market to assess potential changes.

Please let us know if you have any questions about investing in China’s A-Shares or our alternate approach to investing.