David and Goliath aspects to China’s A share market

On 21 June, the financial pages were littered with headlines about China joining the $1.6trn MSCI Emerging Markets index – a move that is apparently going to force portfolio managers to buy locally-listed stocks in Shanghai and Shenzhen en masse. However, the reality is that the beguiling headlines are highlighting a relatively insignificant event in terms of the evolution of the EM landscape.

This is the third occasion on which officials at MSCI have debated the inclusion of China A shares in their benchmark indices and this really is something of a symbolic gesture. The initial inclusion proposal is limited to just 222 stocks, with a weighting of just 5 per cent, meaning they will account for only 0.73 per cent of the benchmark – a tiny exposure.

In addition, the index compilers have laid out a list of demanding liberalisation requirements before they are willing to consider further expansion of Chinese exposure. As such, while it is perfectly conceivable that China’s weighting in the benchmark index could ultimately rise to, say, 40 or even 50 per cent, this is not something that is going to occur imminently. We therefore expect that that any initial uplift to Chinese equities, relating to coordinated purchases across the asset management industry, is likely to be very small.

The real issue at play in China has been the constant need to uphold “best current practice corporate governance” and, hence encourage open transparent freely-floated capital markets, with the need for at least some reflection of this reality in terms of market capitalisation.

Lately that tug of war has become too stretched.

The announcement is also untimely to have a material change announced a week before a key half-year performance period comes to an end. It magnifies the impact of what is something of an arbitrary ruling into a “market event” when it could be handled much less dramatically. It smells very much like an exercise in free marketing.

The A share market which, up until this announcement takes effect, has been entirely excluded from MSCI index coverage (which is not the case with other index providers) is a ‘Goliathesque’ universe which exceeds that of MSCI Europe.

The absence of the whole A shares (Shanghai and Shenzhen markets) meant that this huge economy was neglected by MSCI, with the exception of select H shares. As China continued to grow at rates Europe can only dream of, this mismatch became fanciful. Active investors in EM arbitraged the difference by actively searching out those A shares benefiting from better quality corporate governance and investing in them. In effect they became “non-index plays”, providing active managers with a massive alpha opportunity denied to index huggers. 

As an example, we would point to a leading Chinese domestic appliance maker which acquired a German, top-of- the-line machine to machine manufacturer last year. In effect, the target company became de-listed from an MSCI perspective. We invested in the A shares of the acquirer to exploit that technology, growth potential in China and its non-listed status. In short MSCI indices were fast becoming divorced from investment reality for EM investors.

A parallel would be to drive a car using only the side mirrors. Once the car had passed an unfolding situation, that event would only be visible after the fact, rather than seeing it coming through the front windscreen. That is no way to set an investment universe, however compelling the aggregate free float MSCI criteria are. This lack of coverage leads to arbitrage activity, in respect of the best corporate governance plays in the the A share market, by those active investors able to access local China markets. As we have done in the case of the example above and will continue to do so selectively.

While the extent of the initial inclusion of A shares in the MSCI benchmarks is more token than material, it nevertheless means that the world’s second-largest equity market is beginning to be recognised. Its market capitalisation of over $7trn dwarfs that of the remainder of the EM equity universe aggregated. As is the case with GDP, market cap has little to do with formal Index inclusion. But rarely, if ever, in 30 years of analysing EM markets and various indices, has a distortion of this magnitude occurred. One would have to look back to Japan before it joined the EAFE (Europe Australasia and Far East) indices to find a close parallel. Today, almost 30 years after Japanese equities peaked at a Nikkei index level of almost double its current reading, Japan’s weighting in EAFE is still around 25 per cent.

Tim Love is investment director for emerging market equities at GAM