Sunday, 17 June 2018

Some ETFs to Ride on China A Share MSCI Inclusion

Amidst all the buzz about Trump Kim Summit and US vs Rest-of-World trade war, an important financial event is taking place, that is the inclusion of China A Shares into MSCI Emerging Market Index.

Let's understand some background first.

MSCI and Emerging Market Index
MSCI stands for Morgan Stanley Capital International. It compiles key indices that represent the targeted equity market according to themes, industries or geographical sectors. These indices are often used as benchmark to measure investment funds' performance.

One of the most popular MSCI indices is the MSCI Emerging Market (EM) Index that tracks equity performance from 23 emerging, rapidly growing economy, that includes Brazil, China, India, Indonesia, Russia, South Africa and others.

A Shares Absence from the EM Index
China, although as the world's second largest economy and boasting the second largest equity market, its A shares (stocks listed domestically on the Shanghai and Shenzhen bourses traded in RMB), are not represented on the MSCI EM Index. Only those traded on the Hong Kong exchange, the H Shares, are part of the Index. But not all China big companies list in HK.

There are a few reasons for this. China's equity market has limited accessibility to the global investors, with restrictions on capital flow. MSCI is also probably worried about the corporate governance among these domestically listed entities, authority's excessive market interference (a host of stocks were suspended for trading during early-2015 China market crash), and maturity of domestic market participants given that China's equity market is not as developed as those in the Western world.

China's Economic Reform and Opening Up of Capital Market
But China is gradually opening up its equity market to the global capital via several measures such as increasing the quota of foreign ownership of A shares, relaxing rules on funds flow and implementing the HK-Shanghai/Shenzhen stock connect that allow foreigners' purchase of A shares via Hong Kong.

China has pledge to further open up its capital market as part of the broad efforts to elevate its economic standing to a level that matches its position as the world second largest economy. Its Belt Road Initiative (BRI) entails that its economy and local companies would have more interaction and integration internationally. China can't afford to remain shut from the outside world much longer. This has been stated in the Boao Forum for Asia earlier this year.

MSCI Nod to A Shares Inclusion
So all these developments plus the macro backdrop of China gaining importance globally as an economic power house eventually gained MSCI's agreement to include A shares in its EM index. The fact is that MSCI also can't exclude China any much longer as it is such a heavyweight among the EM - leaving them out would be akin to serving a plate of chicken rice without chicken, its key ingredient.

Details of MSCI Inclusion of A Shares have been widely reported. Just google it.

According to South China Morning Post, The MSCI EM index has funds with around $1.6 trillion assets under management benchmarked to it. A shares inclusion would force unit trust, Exchange Traded Funds (ETFs), pension funds and asset managers all over the world to add A shares into their portfolio.

Analysts estimate that this would result in an initial inflow of $20 billion into Chinese stocks, and eventually $300 billion upon full inclusion. So these funds inflow are expected to fuel the growth of A shares stock price.

Words of Caution
While the macro picture seems conducive, it does not mean that China domestic market's outlook suddenly turns all rosy now.

MSCI has only announced concrete plan of including up to 5% of the free float market share of 230 China traded big caps to be implemented by Sept this year. While analysts expect subsequent inclusion in future, this largely depends on China's progress opening up and de-regulating its capital market. There are many other economic and financial factors to consider too. For example another financial crisis in the near future could throw such plans into disarray.

And China's equity market is largely dominated by retail investors who often treat the stock market as a giant casino. With these largely in-experienced players as the dominant force, the market is more susceptible to volatile movement in face of negative news. A shares are simply not for the faint-hearted.

Plus, index inclusion would not bear fruits over night. Some research shows that previous inclusion of Korea stocks into the EM index saw its equity market rise significantly as late as 2 years after the inclusion.

Some ETFs to Participate in This Development
While the 5% inclusion factor is merely a drop in the vast ocean of A shares, I believe that such move marks the beginning of China equity market joining the mainstream global market. It is a milestone event.

China opening up its domestic economy has just been set in motion and will be a mega trend going forward. I am inclined to think that over one decade or so, its economy will surely be an integral part of, and playing a more active and important role in, the global system. Given this macro backdrop, the A shares will likely see much higher valuation more comparable with the western world, with greater international ownership.

I was researching for some China ETFs to participate in this long term growth. Sharing what I found below, mainly ETFs that track major China indices with relatively low expense ratio.

Please note that these are just some examples of ETFs with exposure to China major companies. They are not recommendation to buy/sell. At this moment I do not hold any position in these ETFs.

iShares MSCI China Index ETF (2801)
Traded on HKEX, this ETF tracks the MSCI China Index that comprises large and mid-cap China companies listed in China, Hong Kong, and overseas.

iShares Core CSI 300 Index ETF (2846)
This ETF gives investors pure exposure to A shares, as it mirrors performance of CSI 300 Index that consists of 300 of the largest and most liquid A shares listed in Shanghai or Shenzhen.

iShares FTSE A50 China Index ETF (2823)
This fund also provides pure exposure to A shares, but a smaller group of companies covered under the FTSE A50 Index - 50 largest stocks listed on Shanghai or Shenzhen bourses.

Hang Seng China Enterprises Index ETF (2828)
Should you be uncomfortable investing in unfamiliar A shares, consider the H shares via this ETF, that tracks the Hang Seng China Enterprises Index covering Mainland securities listed in HK.


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