China domestic listed shares enter the MSCI index - more risk for investors?

While the move is a major milestone for China, state intervention and poor corporate governance remain major concerns. 

Any investor who owns an emerging market or world equities tracker fund or ETF that follows an MSCI index will have found themselves the proud new owner of Chinese domestic-listed equities as of today, 1 June 2018.

Following a decision made in 2017, MSCI will start to include around 230 Chinese ‘A-shares’ (shares of mainland China-based companies listed on the two domestic Chinese markets in Shenzhen and Shanghai) on both its Emerging Markets index and All Country World index. These shares were historically available only to domestic investors with foreign investment restricted.

With only 230 odd shares included, this will account for little of any investor’s portfolio. A-shares will have an aggregate weight of just 0.39 per cent in the MSCI Emerging Market index, for example. However, as Jason Hollands of Tilney Bestinvest notes: ‘This is certainly a milestone in the greater integration of Chinese companies into international capital markets, [albeit] incremental in nature and progress.’

In the future, further Chinese A-shares are expected to be listed. Consequently, assuming inclusion continues, China will form an increasingly large part of the index. ‘At current market values, fuller inclusion of large-cap A-shares would make China an estimated 42 per cent of the MSCI Emerging Markets index, even using a fairly limited list of A-shares,’ notes Andrew Mattock, a portfolio manager at Matthews Asia.

Of course, Chinese companies are already listed on MSCI indices, but these are shares listed on foreign markets, with investor favourites such as Alibaba and Tencent listed on the New York Stock Exchange and Hong Kong Exchange respectively. But A-shares are a different animal.

Many of China’s most successful foreign-listed companies are part of the tech sector, so the-called ‘new economy’. Not so for the domestic listing: China A-shares are more ‘old economy,’ focusing on oil, banking and insurance businesses.

Many of these businesses are state-owned or -controlled. This, says Hollands, is a problem. State-owned firms are often ‘marshalled to act in accordance with the political objectives of the Communist regime and these may not always be consistent with investors’ priorities.’

Even for non state-owned firms, corporate governance is a potential issue. ‘It is also a real minefield to navigate, as standards of corporate governance and transparency lag those of developed markets,’ says Hollands.

However, the opening up of China to foreign investors may lead to incentives for reform. As Oliver Smith, portfolio manager at IG, notes: ‘to attract significant future foreign capital flows, there will be demands for more openness and transparency, which can only be positive for shareholders in the long run.’

At the same time, the Chinese A-share market is much more unpredictable than other stock markets of similar size. While Chinese markets only reopened a few decades ago (after being shut following the Communist Party’s seizure of power), investing has taken off among ordinary Chinese citizens. With retail investors often pursuing highly speculative investing strategies, markets have been prone to unpredictable market swing.

However, since then the Chinese government has stepped up measures to reduce market volatility, including the use of state-backed investment funds and warning both investors and brokers to limit certain trades. 

Again, however, MSCI inclusion and increased foreign investment could have a positive effect. As more foreign investors – including large institutional investors and tracker funds – buy up A-shares, the ability of domestic retail investors to swing the market should be diluted, hopefully reducing the incentive for state involvement in the market. 

-Inside Money: Don’t get left in the lurch in emerging market crisis

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