Get ready for more mainland-listed Chinese stocks in mutual funds and ETFs. Starting June 1, MSCI will be including Chinese A-shares in its emerging markets and MSCI ACWI (All-Country Wide) indexes as well as in its China index.
A-shares trade on the two primary Chinese stock exchanges — in Shanghai and Shenzhen — and are priced in Renminbi, the local currency. They have become more accessible to foreign investors since Chinese authorities agreed to a trading link between the Shanghai and Hong Kong stock exchanges in 2014 known as Stock Connect, which was extended to include the Shenzhen exchange in 2016.
As a result of Stock Connect and increasing demand from investors, MSCI last June announced plans to include China A-shares in its indexes beginning this year, according to Sebastien Lieblich, global head of Index Management Research at MSCI.
About 230 large-cap stocks will be included as partial weightings in the MSCI indexes, using only about 5% of the free float-adjusted market capitalization of each company, which will exclude the weighting of any China state ownership, explained Lieblich.
Initially the China A shares will constitute about 4-5% of the weight of MSCI China index, about 0.8% of it MSCI Emerging Market index and about 0.15% of its ACWI Index, which will have a minimal impact on funds and ETFs that track the index such as iShares Emerging Markets Index ETF (EEM) as well as actively managed funds that track the MSCI China, emerging markets and ACWI indexes
Chinese stocks listed in Hong Kong and overseas currently have a 30.9% weighting in EEM, which would increase to 31.7% following the inclusion of China A shares.
Eventually, as heavier weights of China A shares are included in the MSCI index, including the addition of mid-cap and small-cap A shares, Chinese equities could constitute over 45% of the firm’s Emerging Market index, says Lieblich.
Vanguard’s Emerging Markets Stock Index Fund (VEIEX) and Emerging Markets ETF ( VWO) already include China A shares because they track the FTSE Emerging Markets Index which added them previously.
Ahead of the June move, MSCI announced the creation of 12 new China A share indexes “to prepare global investors for the next step of the China A inclusion process where China A shares are fully represented.”
Morningstar analyst Daniel Sotiroff likened MSCI’s move in June to the opening of a dam that will lead to heavier weightings of Chinese stocks in emerging market indexes. “It’s just a matter of time.”
“From a diversification standpoint this is going in the wrong direction for emerging market indexes,” says Sotiroff, adding that when one country or currency dominates an index, the risk rise because they drive much of the outcome.
“China is the big one now,” says Sotiroff. In the past it was Japan, which dominated foreign developed markets indexes, weighing as much as 55% of the MSCI World Indexes excluding the U.S., says Sotiroff. Those indexes didn’t perform as well as U.S. indexes because of the heavy weighting of Japan.
He prefers index like DFA Emerging Markets portfolio which caps the weight of individual countries at 17.5% or even iShares Edge MSCI Minimum Volatility Emerging Markets ETF (EEMV), which has about a 25% weighting to China stocks versus about 30% for the MSCI Emerging Market Index.
Another potential risk for funds and ETFs that focus on China stocks is the potential levy of new tariffs on Chinese exports in the U.S., which President Trump is reportedly preparing. Robert Lighthizer, the United States trade representative, has presented Trump a plan that targets $30 billion in Chinese imports for one year but, according to Politico, Trump wants an even higher figure.
Sotiroff suggests investors dig down into any China index to identify which companies could be affected though he says tariffs and sanctions are “par for the course with emerging markets.”