MSCI decision on China A-shares inclusion: A drop in the ocean or a big wake-up call?

The MSCI Inc. annual review process outcome was released at the end of June. For the fourth time in a row, the decision on including onshore Chinese equities -“ A-shares”- by the leading index provider was on the cards. This time, it was a 'Yes!'

Huge progress has been made in China, especially in terms of access, since the first review in 2014, and the positive decision is a welcome one. The question one should focus on is, ‘How important is it for investors and for China itself?’

It takes two to tango

The MSCI Inc. decision on China was not a big surprise to us. MSCI has recognised that a number of significant improvements have been made over the last 12 months, especially as far as accessibility is concerned. Shenzhen Connect was launched 6 months ago, and in conjunction with this launch, the aggregated quota was removed. Rules regarding stock suspension that had been made both clearer and stricter, have been properly implemented. The requirement to get pre-approval by local stock exchanges to issue A-shares products such as ETFs (“Anti-competitive clause”) has been loosened.

MSCI on its side also made some significant changes in its proposal. Focusing only on large capitalisations accessible via Connect, and automatically removing stocks that have been suspended for more than 50 consecutive days during the previous 12 months at each rebalancing, MSCI is reducing the eligible number of stocks from 448 to 222. The targeted initial weight of China A-share names in the MSCI EM index will be 0.73% a year from now, versus 1.5% considered in the past. Keeping the initial benchmark universe at a reasonable size to improve investability and ensure liquidity has been key in reaching a positive decision.

A drop in the ocean?

The decision to include 222 Chinese A-shares in one year’s time, for a total weight of 73 bps, is not going to rock the boat for the Chinese A-shares market. The second-largest market in the world, with a total market cap of USD 7tn and daily trading volumes oscillating between USD 50bn and 200bn, and completely dominated by domestic investors, will hardly notice the USD 12bn of inflows the MSCI decision implies in 12 months’ time.

A big wake-up call…

Global investors have largely ignored the Chinese onshore markets. When the markets started to open up in 2003, through the so-called QFII scheme (Qualified Foreign Institutional Investors), which was one of the first major attempts to attract - through licensing - global institutional investors to invest in the RMB-denominated capital markets, and later on the R-QFII scheme in 2011, there was no rush to the gate. The Stock Connect scheme launched in 2014 was by itself a much stronger signal of loosening the access, as it is not license-based. Despite some pick-up of interest in terms of new product development, flows have remained quite limited, and it is estimated that only 1.5% of the domestic equity market is owned by foreigners. China’s equity market remains mainly driven by domestic investors. But now that MSCI has decided to include A-shares in its indices, the gravitational importance of China A-shares is confirmed. It will take a few years, but at the end of the process, China A-shares might represent as much as 20% of the MSCI EM index. MSCI indices are tracked by around USD 1.5tn in assets under management. Investors and asset allocators need to speed up the development of their research capabilities and infrastructure operations (trading, custodians, lawyers etc.) to adequately handle the world’s second largest equity market.

A stock picker market

In a market dominated by retail investors, and with the domestic institutional asset management industry still experiencing a high level of rotation between themes and style through the year, mispricing opportunities are numerous. Investing on A-share markets is a stock picking exercise. Since 2013, when we were granted a QFII license – as the first asset manager in the Nordics – we have been very successful at this exercise, both in terms of relative and absolute performance.

Focus on long term structural opp-ortunities to outperform the market

With more than 500% price return performance difference between “New economy” and “Old economy” related stocks since 2010, it is critical to realise that the current structural transformation of the Chinese economy and society is
benefitting predominantly new economy themes. In order to generate long-term outperformance, it is important to focus on the most structural trends offered by the new economy in order to avoid the “hot theme” of the month (or the week). Environmental protection industries are offering such long-term structural exposure to China’s new economy. With 50% of global investment in the cleantech space happening in China these days, and with the clear ambitions of the Chinese government, environmental protection industries and Chinese domestic environmental champions are offering very appealing investment opportunities for international investors. Active in the field of clean energy, energy efficiency, new energy vehicles, water treatment and so on, companies in this investment universe are currently trading at PE17 15x for EPS16/17 CAGR of +20%.