A stock board in Shanghai. (Photo: AP)

China is already the world’s second largest and fastest growing economy and a member of the World Trade Organization, and its stock market will soon become significantly more important for investors. MSCI, a leading provider of global equity indexes, has announced it will be adding China A shares, which trade on the mainland on the Shanghai and Shenzhen indexes, to its emerging market index.

“The MSCI inclusion is significant … It will pave the way for global capital inflows into China’s A shares by linking them to the most dominant trend in asset management — the increasing adoption of low-cost passive index funds,” wrote analysts from Moody’s Investors Service.

MSCI will be phasing in the inclusion of China A shares, first by launching provisional indexes — an MSCI China A International Large Cap Provisional Index launched June 21, and additional global and regional provisional indexes including the MSCI Emerging Markets Provisional Index will be released in August. Then, formal adoption of China A Shares into the MSCI Emerging Markets Index and MSCI ACWI (All Country World Index, which includes the EM Index) will follow in May, then August 2018.

Altogether 222 China A large-cap stocks will be included in the MSCI Emerging Markets Index, representing about 0.73% of the emerging markets index, ultimately China A-shares could make up an estimated 20% weight within the MSCI Emerging market index, according to Moody’s.

“While the immediate market impact may be muted, the long-term investor implications are likely to be far-reaching,” according to an analysis by BlackRock.

Its iShares Core MSCI Emerging Markets ETF (IEMG) and iShares MSCI Emerging Markets ETF (EEM), the second and third largest emerging market ETFs, with almost $65 billion in combined assets, are both linked to the MSCI EM index.

The largest EM index ETF, Vanguard FTSE Emerging Markets ETF (VWO), with $55 billion in assets, tracks the FTSE Emerging Markets All Cap China A Inclusion Index, which has a 5% stake in China A shares.

Inclusion of China A shares in the MSCI Emerging Market Index is expected to attract more institutional investors to China’s equity market, which could lead to a more balanced and stable market, according to BlackRock. Moody’s says the change has the potential to improve governance policies of Chinese firms.

The elevation of China A shares could impact not only investors who buy global and international index funds linked to emerging market indexes, but also actively managed funds, especially those benchmarked to the MSCI emerging market index.

Those funds “will be competing to beat the index and are likely going to have to utilize A shares at some point to generate returns in excess of benchmark,”  said Stephen Tu, senior analyst at Moody’s Investors Service.

He noted that despite the elevation of China’s A shares into the global market, some of the risks that precluded their inclusion in major market indexes for several years remain because Chinese capital markets and currencies are still largely state-controlled.

Morningstar’s Jackie Choy cautions in an analysis that “investors should continue to understand further the fundamentals of the A share market, as well as the makeup of the indices tracked by the various funds tied to them, as the A shares exposures could be quite different for any chosen ETF.”

Matthews Asia, which already invests in China A shares in its actively managed funds, says investors should also be aware that “many quality A share companies in growing industries can be priced at rich valuation multiples.”

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