On the first of June, Chinese A-shares will be included in MSCI indices for the first time, forming roughly 0.73% of the MSCI Emerging Markets index and 0.1% of the MSCI All Country World Index. The AIM Global High Conviction Fund believes this is a significant event for Asian markets and, in particular, Chinese listed shares. This is likely just the beginning, with the index weighting increasing over time as China’s capital markets are deregulated.

Source: UBS, Bloomberg, Thomson Datastream

Global universe

The key point is that the Chinese onshore capital markets are in the process of being plugged into the global investible universe. This is a transformational, structural event that will progressively connect China’s onshore capital markets with global markets. The preliminary list of 234 Chinese A-shares in MSCI stock indices will make up approximately the following allocations:

Source: Forsyth Barr, MSCI

The inclusion means ETFs, international retirement plans and endowments that track an MSCI index will, for the first time, have to buy many of the A-shares that will now be MSCI constituents. As this occurs, the Chinese domestic markets (which are relatively under-researched by international standards) will see increasing broker and investment bank coverage. Subsequently, this will see the increasing presence of institutional investors in the A-share markets, as these markets largely consist of only retail investors.

Trading volumes in the A-share market are more than 10 times that of Hong Kong, with 86% of A-share volumes driven by retail investors (see graph below). In terms of behavioural differences, according to UBS, the investors tend to prefer small caps and growth stocks; are prone to momentum behaviour, as seen in 2007 and 2015; and tend to be more micro than macro. The change should make the A-share markets more sophisticated, improve liquidity and see fundamentals drive share prices instead of short-term market noise. It should also be noted that less than 2% of the A-share market is owned by international investors – this compares with approximately 50% of foreign ownership of the FTSE 100 in the UK.

Source: UBS

The effects of the inclusion can already be seen in terms of recent fund flow. Foreign money continues to pile into A-shares via Northbound Connect, to the extent that YTD cumulative purchases have now surpassed net Southbound buying of A-shares by Mainland investors this year. Citigroup expects $48 billion of annual inflow to A-shares on the inclusion, although MSCI estimate the initial inclusion to see a flow of around $17 billion in passive funds, which could rise to $35 billion in coming years.

This flow can also be seen into emerging market equity funds. Emerging market fund flow has seen the largest run of inflows on a 1-year rolling basis since 2000 and we believe it is the Chinese MSCI inclusion that has been driving this.

Future flows

While 0.73% weighting represents only a tiny part of the A-share market, if full allocation is achieved in the coming years, then Chinese A-shares could eventually account for 18% of the MSCI emerging market index. The MSCI EM Index currently has more than US$1.6 trillion benchmarked to it. Despite the Asia ex-Japan region (including China A-Shares) possessing more listed stocks, with a market capitalisation greater than either the US or Europe, it retains a minor weighting in most global portfolios. The top 10 Chinese A-share constituents can be seen below:

Even though Chinese exposure can be achieved through international listings, such as Alibaba or JD.com in New York, the A-share market provides a wider group of companies exposed to an increasingly consumer driven economy. This is a theme I’m invested in and continue to believe in. In terms of valuations, Chinese A-shares are at near record lows relative to overseas listed shares.

Although we may not see an immediate change in markets, I believe this is a significant occasion for the rise of investing in China. It is a signal that MSCI has deemed the regulatory environment, liquidity and accounting principles as satisfactory. It is just the beginning and the continued flow will provide a tailwind to Asian and Chinese investing, as fund managers around the world can no longer get away with having ‘no China’ in their portfolios.

I am very bullish China and believe this is where some of the best growth opportunities lie, at reasonable valuations.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regard to your circumstances.