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When trackers won't do: investing in China A-shares
Chinese A-shares offer exciting investment opportunities - but it's also a market strewn with potholes. That's why an active approach makes most sense.
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MSCI’s decision to start incorporating China’s domestically-listed A-shares in its emerging market (EM) equity benchmarks from last summer was momentous. At long last, one of the world’s most significant stock markets was being integrated into the global financial system.
heavyweight
MSCI EM index with 20% and 100% weighting of Chinese A-shares, % of total index
Source: MSCI
But the index provider's much anticipated move has also left investors standing at the edge of a minefield.
That’s because China’s mainland market is particularly unsuited for passive index-based investing – which for many investors in emerging markets has become the default approach.
Not only does China feature a number of economic fault lines, but the nature of its equity market is a potential trap for the unwary. We believe that the most effective way for investors to skirt a plethora of possible risks is to take a dynamic, active approach to Chinese A-shares.
Growing, growing
MSCI is increasing the number of A-shares it is accepting into its EM index – which is tracked by investors controlling more than USD1.6 trillion in assets – in three steps. By 2020, 20 per cent of Chinese large- and mid-cap A-shares will be represented in the index. At that point, mainland Chinese stocks will make up some 3.4 per cent of the benchmark. Were all A-shares to be incorporated, they would account for more than 16 per cent. Adding in Chinese equities listed outside of the country, and China’s weighting would jump to more than 40 per cent, from around 30 per cent now1.
This growing heft – which was made possible with the expansion of Stock Connect, an arrangement that allows international investors to trade Shanghai- and Shenzhen-listed securities on the Hong Kong Stock Exchange – could eventually allow the mainland Chinese market to rival Wall Street. For that to happen, though, a number of hurdles need to be overcome first.
Chinese challenges
To begin with, there's the matter of governance and regulation. The Chinese market falls short of western institutional standards on a number of fronts, not least in how companies are regulated. Chinese companies that are also listed in Hong Kong or New York – traded as H-shares or American Depository Receipts – have to meet strict governance rules. By contrast, minority shareholders on the mainland have significantly weaker legal protection. Buying an index makes it impossible to separate out the bad from the good.
More worrying still is that Beijing has lately declined to bail out companies that claimed implicit government guarantees or political pull.
Then there’s index concentration. The A-shares incorporated into the MSCI indices are heavily weighted to financials and old economy industrials. The former are vulnerable to China’s high rates of corporate leverage – the value of corporate bond defaults tripled in 2018.
Meanwhile, old economy sectors are at risk from Beijing's plan to tilt the economy away from investment towards consumption. Old economy stocks also suffer from significant overcapacity and from any reheating of trade wars. Even after some rationalisation, China’s coal and steel industries remain dangerously bloated and vulnerable to both US tariffs and domestic environmental measures.
China may represent the future of investing, but it's a future strewn with potholes.
On the flip side, the MSCI EM equity index is under represented in sectors that we believe have the greatest potential – the Internet and healthcare. The former should benefit from China’s huge investment in education and research, while the latter from growth of China’s middle class and from its ageing population.
Also making passive investing in Chinese stocks tricky are abrupt shifts in fiscal and monetary policy – last summer the Chinese central bank was draining liquidity; it’s since shifted back to supporting loan growth – make it particularly important to be able to select stocks rather than be tied to an index.
Moreover, routine trading suspensions continue to bedevil investors in A-shares. It’s relatively easy for mainland-listed companies to suspend trading in their shares, and for periods of as long as six months. Indeed, half of all A-share companies had suspended their shares in 2015 during a severe bout of stock market turbulence.
The opening up of mainland China’s equity market to foreign investors offers huge potential. But buying such stocks through passive, indexed products is a risky choice. Being locked into an index provider’s share weighting exposes investors to a number of risks. It leaves them over-exposed to the most vulnerable sectors as the Chinese economy undergoes a significant re-balancing. And it doesn’t allow them to factor in differing qualities of corporate governance. China may represent the future of investing, but it’s a future strewn with potholes.
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