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Hype vs. hope: experts clash over deferral of A-shares addition

Hype vs. hope: experts clash over deferral of A-shares addition

Index provider MSCI’s decision to delay adding China-listed shares to its key market benchmarks has divided fund managers, with some branding it ‘overhyped silliness’.

The US-based company opted to postpone adding China A-shares to its World and EM (Emerging Markets) Indices citing a need to sort issues surrounding market access.

The addition of the market to the indices was seen as another key step in China’s efforts to internationalise, as well as promoting its currency and attracting foreign capital.

While the A-shares market looks likely to be gradually added over time, or once necessary criteria is met, the fund management industry has presented a mixed response to the news.

Size of shift is overstated

According to Citywire + rated Thomas Schaffner of Swiss group Vontobel, while the addition is welcomed, believes the overall impact of foreign flows into A-shares may be overstated.

As expected, the process of Chinese A-shares being accepted in the MSCI Emerging Index is going to be a gradual one. When the process does start, it will be much more important for global investors who have to adhere to benchmarks than for the actual domestic Chinese equity market.

The potential inflows from global investors will be relatively small compared to the total trading volumes of the A-share market, hence the impact on valuation will be limited.

The other trend that we are seeing, which would act as a counterbalance to foreign flows coming into the Chinese A-share market, is the fact that domestic Chinese investors are having their restrictions relaxed and are able to invest increasingly in international investments, where until now they have been very much restricted to the home market.

A-shares euphoria is foolish

Mike Sell, head of Asian investment at UK boutique Alquity, offered a more critical appraisal and said the huge emphasis placed on the decision is problematic for Asian and EM investors.

Several times a year markets get very excited about the inclusion of various countries in various indices. Today it is A-shares. This is to completely miss the point of investing.

We should be buying companies because they are well run (with good forward looking environmental, social and governance factors), have a good business model and deliver returns to shareholders.  

Whether a company is in an index or not is irrelevant in terms of the above. An un-benchmarked approach to investing, focusing on fundamentals rather than an artificial index construction surely is the more logical and correct approach.

Investors need to return to basics - and ask themselves 'do I want to buy this company' - and not be swayed by overhyped silliness such as this.  

Dislocation risk dulled

Citywire A-rated Jian Shi Cortesi of GAM, speaking ahead of the announcement, said a gradual integration was always the most likely path as this helps reduce the threat of market volatility.

There could be a series of gradual weighting increases over a few years; this seems sensible given there needs to be enough liquidity in the market for the buy side to purchase underlying A-shares.

However, currently China’s QFII schemes and Stock Connect programme have quotas and can digest only a certain amount of flows, and if all index providers announce an inclusion in short proximity, the potential for market dislocation could be quite large.

Correction could come

Julian Mayo, co-chief investment officer at Charlemagne Capital, was not surprised by the outcome but believes the emphasis placed on the neighbouring H-shares market could cause volatility.

It’s no surprise that the move to allow A-shares in to the MSCI Emerging Index will happen more gradually. It is however definitely a sign that MSCI want to bring A-shares into the index, which in the long run will make a difference to the market, as there will be a lot of money benchmarked against the A-shares.

The A-share market is currently being driven up by large amounts of liquidity in the domestic market. Foreign investors are responding by going into the H-shares market as a way of tapping the trend, as they hope that the H-shares will play catch up.

To this extent, we are talking about hot money flows and it’s likely for this to correct when liquidity is steered again outside of China by other more attractive valuation opportunities.

Right to call for caution

The speed of integration needed to be slowed, says Nicholas Yeo, head of equities for China/Hong Kong, at Aberdeen Asset Management, as more clarity is needed in key areas.

We are not surprised by the MSCI’s decision in excluding China A-shares in their indices this year. The pace of market liberalisation in China has been accelerating with a number of key changes – RQFII expansion, the Shanghai-Hong Kong Stock Connect, the internationalisation of the yuan, etc.

Foreign investors can now access A-shares more easily than ever before which is why the MSCI has started to consider integrating them into their indices.

However, many obstacles remain. For example, the Stock Connect scheme does not cover all stocks listed in Shanghai (smaller companies that are not part of an index are left out), while stocks listed in Shenzhen are also excluded for the time being.

More clarity is also needed on the legal interpretation of the beneficial ownership of A-shares purchased through the scheme. With regards to QFII and RQII, there’s uncertainty surrounding the approval process even though barriers to entry have been lowered.

Having said all this, the situation is fluid and these issues will be resolved, eventually. It’s only a matter of time before A-shares are a component of most global indices because other Asian markets have gone through the same process. MSCI is likely to start slowly, with a small weighting, before making A-shares a more influential component of their benchmarks.     

As bottom-up investors we are benchmark agnostic and, as a first step, we still advise investors to access China’s growth story via companies listed in offshore jurisdictions that offer more transparency and investor protection. However, as the A-share market slowly opens up to more foreign funds demanding higher standards of corporate governance, things should improve.

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