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ETF Specialist

China Opens 'A' Door for Foreign Investors

Index funds are likely to add China A-Shares in the coming years.

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Most investors do not currently have exposure to the large, $3 trillion (float-adjusted) Shanghai and Shenzhen equity markets, as China has a mostly closed capital account, under which money cannot freely flow into and out of China.

However, the door is starting to open.

Over the past few years, China has implemented a number of initiatives to allow for controlled foreign fund flows into its onshore equity markets, as part of its goal to gradually liberalize its economy. Index provider MSCI is monitoring these efforts and currently has Shanghai- and Shenzhen-listed stocks, also known as China A-Shares, on a watchlist for inclusion in its global equity indexes.

The addition of China A-Shares would have a significant impact on the MSCI Emerging Markets Index. China already accounts for 25%-30% (via Hong Kong-listed Chinese stocks) in this benchmark, so the addition of China A-Shares would result in a much larger China allocation.

Vanguard decided to get ahead of this possible benchmark change (and potentially large foreign fund inflows) by announcing that it will add China A-Shares to its emerging-markets index fund.  Vanguard Emerging Markets Stock Index Fund ((VEIEX), (VWO)) currently tracks the FTSE Emerging Index, but later this year it will switch to an index that includes China A-Shares at a capped level. This China A-Share allocation will rise gradually as China liberalizes foreign investor access to its equity markets.

Investors may be concerned about a large allocation to China. Most listed Chinese companies are government-controlled firms, and at times, state interests can take precedence over profitability. The government maintains a very heavy hand in the market, as it recently helped fuel an equity market bubble only to have to take aggressive measures to try to mitigate a subsequent slide. China is also trying to implement a wide range of economic reforms, as well as manage a slowing economy. There is regulatory uncertainty regarding how China plans to meet these goals, and this continues to be a significant source of market volatility.

What Are China A-Shares?
China A-Shares are the equities of China-domiciled firms that are listed on either the Shanghai or Shenzhen stock exchanges (or "onshore" markets). Foreigners have limited access to these shares because China has a mostly closed capital account, whereby investors, as well as companies and banks, must comply with strict rules when moving money into and out of the country.

Currently, most investors and asset managers that invest in Chinese stocks hold Chinese companies listed on overseas exchanges (or "offshore" markets), chiefly Hong Kong. Historically, it was the larger, fiscally healthier, and politically favored companies that were allowed to list offshore to tap a global investor base. This included companies such as wireless service provider  China Mobile (CHL) and integrated energy firm  PetroChina (PTR). With this legacy, overseas-listed Chinese firms are generally larger and more established companies. Shenzhen- and Shanghai-listed companies, on the other hand, continue to be smaller and less established. That said, there is a greater breadth of companies and a significantly larger IPO pipeline in the onshore markets. But it is important to note that the majority of Chinese firms, both offshore- and onshore-listed, are state-controlled.

MSCI's Plan for Adding China A-Shares
The MSCI Emerging Markets Index is the most popular emerging-markets benchmark. As such, a decision to include China A-Shares would drive significant flows into the onshore China market. Index funds and exchange-traded funds (such as  iShares MSCI Emerging Markets (EEM), which has $21 billion in assets) that track this index would likely add China A-Shares to their portfolios in tandem with MSCI.

Actively managed emerging-markets funds may not immediately follow MSCI's decision to add China A-Shares. But portfolio managers who focus on minimizing tracking error will likely add China A-Shares soon after they are added to the benchmarks. Over the long term, China A-Shares may be increasingly viewed as part of the global equity investment universe. If this were to happen, global, international, and emerging-markets equity portfolio managers may begin investing in China A-Shares.

At its June 2015 Annual Market Classification Review announcement, MSCI stated that limited market accessibility continues to be an obstacle to China A-Shares' inclusion in its equity indexes. MSCI wants Chinese regulators to provide more transparency on how they allocate quotas and to further ease capital mobility restrictions for all types of foreign investors. MSCI has said that when it does initially add China A-Shares to its indexes, it will cap their weighting in the benchmark. As China continues to open its market to foreign investors, MSCI will increase the A-Shares' weighting, which will likely take several years.

The exhibit below illustrates how the addition of China A-Shares would affect the MSCI Emerging Markets Index. Initially, MSCI will include China A-Shares at 5% of its free-float market-cap weighting. At this initial level, China A-Shares would account for only 1% of the MSCI Emerging Markets Index. MSCI plans to gradually raise the inclusion factor as China liberalizes foreign investor access into its onshore market. Should China completely open its capital markets to all investors, MSCI would weigh China A-Shares at 100% of its free-float market cap. Under this scenario, total China exposure, which would include offshore listings, would be 42%. (All percentages are based on prices as of June 30, 2015).


 

Vanguard Adding A-Shares to Emerging-Markets Index Fund in Late 2015
Once MSCI decides to add China A-Shares to its indexes, the onshore Chinese equity markets will likely see strong foreign inflows, which may lift prices. To get ahead of this potentially large inflow, Vanguard will start to add China A-Shares later this year to its $54 billion Vanguard Emerging Markets Stock Index Fund by transitioning from its current FTSE Emerging Index benchmark to the newly created FTSE Emerging Markets All Cap China A Inclusion Index. This change will be implemented across all the share classes of that fund.

Vanguard will slowly add China A-Shares (and trim the weightings in existing holdings) over the course of a year, starting in late 2015. By taking a gradual approach, Vanguard hopes to minimize front-running and transaction costs. At current market prices, China A-Shares will account for about 6% of the fund after this transition is complete. When FTSE Russell raises the inclusion factor for China A-Shares (as China further opens its market to foreign investors) in its China A Inclusion Indexes, Vanguard will follow suit. If China A-Shares were to be included at its full free-float market-cap weight, it would account for 26% of the fund, for a total China allocation, including Hong Kong listings, of 49% (using prices as of June 30, 2015).

Vanguard says that the addition of China A-Shares will help further diversify this fund. Vanguard is only adding China A-Shares to Vanguard Emerging Markets Stock Index Fund. It is not adding A-Shares to any of its other funds, such as  Vanguard Total International Stock Index (VGTSX), which is used in Vanguard's Target Date and LifeStrategy allocation funds.

At this time, it is impossible to ascertain whether Vanguard's decision to be the first to add China A-Shares was a good one for investors in its funds. China A-Shares will likely become part of the global investment universe within the next few years, and by being a first mover, Vanguard may be getting in prior to large foreign fund flows, which could drive up the prices of China A-Shares. Luckily for Vanguard, it did not add China A-Shares at the market peak in early June, when the firm announced that it was planning to add China A-Shares later in the year.

What Does This Mean For Investors?
Investors who hold index funds that track the MSCI Emerging Markets Index are likely to see China A-Shares added to their portfolios in the coming years. Over time, China A-Shares could comprise about 25% of an emerging-markets index fund (for a total China allocation of 40%-50%, including offshore listings). Given the volatility of the China A-Share market, a large China allocation should be a concern for investors.

Alternatively, investors may want to consider actively managed funds, particularly those run by portfolio managers who are not very concerned about tracking error. When MSCI and FTSE Russell add China A-Shares to their indexes, portfolio managers of actively managed funds would have discretion as to when (or if) they would add China A-Shares. Historically, actively managed funds have been underweight China, relative to the MSCI Emerging Markets Index. This remains true today, as the average China allocation for funds in the diversified emerging-markets Morningstar Category (which includes actively managed funds) is 18%, which is less than the MSCI Emerging Market Index's 23%. Among diversified emerging-markets funds that have a Positive Morningstar Analyst Rating, the average exposure to China is even lower, at 13%. This suggests that the portfolio managers of these funds run fairly benchmark-agnostic portfolios.

This article is an abridged version of a recently published research paper under the same title. For a copy of this paper, please contact the author at patricia.oey@morningstar.com


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Patricia Oey does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.