MSCI index change ‘massive’ for China markets

China-Hong-Kong-Asia-700x450.jpgThe MSCI’s inclusion of Chinese American Depository Receipts (ADRs) into its indexes, which is expected to be announced tonight, is a “massive change” for the indexes, say experts.

The MSCI is expected to announce the inclusion of Chinese ADRs after US market close tonight. The inclusion will occur in two stages: one at the end of November and another in May 2016.

The move is big for China, says Eng Teck Tan, senior portfolio manager at Nikko Asset Management, and will see the representation of technology firms in the China index increase, while China’s share of the emerging market and global indexes will rise.

ADRs are predominantly invested in internet and technology firms, such as Alibaba, Baidu and Netease. The inclusion of ADRs will take the technology representation of the MSCI China index up from 13.5 per cent to 24 per cent by the end of May, says Mike Kerley, Asia fund manager at Henderson Global Investors.

Meanwhile, banks, which make up about 40 per cent of the index currently, will drop to 33 per cent of it.

“Because all these companies are technology and internet that sector weighting becomes much more significant,” Kerley says.

“Meanwhile, as the inclusion of the ADRs will come largely at the expense of Chinese banks, Chinese banks may underperform in the medium term as they are expected to see some selling.”

“From a valuation standpoint it will make the index look more expensive. Technology companies trade at a much higher multiple than Chinese banks. China always trades at a big discount to the rest of Asia and that discount would narrow,” says Kerley.

“As these new constituent stocks are more geared towards domestic consumption and ‘New China’, it could also attract flows from actively-managed funds as investors are looking for exciting and sustainable growth stories in the low-growth world,” says Raymond Ma, portfolio manager of Fidelity China Consumer Fund.

The inclusion also changes China’s weighting in emerging market funds, up from 24 per cent to 27 per cent, while in the world index China will now rise from 0.5 per cent to about 1.1 per cent in June next year.

While the biggest implication will be for index managers, active managers need to increase their coverage of these stocks.

“There needs to be more coverage. A lot of these stocks have never really been a big part of the market so there are not the resources to cover them … investors have to be more proactive in looking at them,” says Teck Tan.

The ADR inclusion paves the way for the inclusion of A-shares in the MSCI indexes, says Teck Tan. He says the structure of many of the ADRs, which MSCI previously opposed, share similarities with the A-Shares market.

“By next year the MSCI will consider including the A-shares since one of the reasons they didn’t want to include them has already been thrown out,” he says.

Should A-shares be included that significantly increases China’s representation in the global index, says Kerley.

“By June next year China will be more than 3 per cent of the global index if you put A-shares in as well. At that point it becomes slightly behind the weighting of Germany,” he says.

What is a Chinese American Depository Receipt? 

Chinese ADRs are a way to buy shares in a Chinese firm while keeping it denominated in US Dollars. Issued by a US bank, an ADR represents shares in a foreign stock that is traded on a US exchange, such as the Nasdaq. The underlying shares are held by a US finance firm overseas.