The Oriental Pearl Radio & Television Tower in Shanghai.

MSCI is quadrupling the weighting of domestically traded Chinese stocks in its global indexes starting this May.

In a three-step plan, the share of China A large-cap shares will increase from a 5% inclusion factor currently to a 10% inclusion factor in May, then to 15% in August and 20% in November, at which point the indexes will also add some mid-cap China A shares and Chi-Next stocks, which trade on a Nasdaq-like board at the the Shenzhen Stock Exchange.

The inclusion factor functions as a discount on how many China A shares will be included in the indexes due to limits that China imposes on foreign ownership of domestically traded stocks and MSCI’s gradual approach to inclusion.

MSCI explains on its website that international institutional investors it had consulted were leery of a weight increase beyond 20%, which would require Chinese authorities to address some “accessibility concerns,” including access to hedging and derivatives.

Once its three-step process is completed, MSCI estimates that China A shares will account for 3.3% of the MSCI Emerging Markets Index, 4% of the MSCI AC (All Country) ex Japan Index, 10.4% of the MSCI China Index and just 0.4% of the MSCI All Country World Index. 

There will be 253 large-cap and 168 mid-cap China A shares, including 27 ChiNext shares in the MSCI Emerging Markets and MSCI China indexes.

“This is a long time overdue,” said Andrew Mattock, lead portfolio manager at Matthews Asia China Fund, about the MSCI announcement. “You can’t have a country account for 15% or more of world GDP make up just 1% of global portfolios. … Our hope is that this will improve people’s awareness how little they have invested in China.”

China is not only the world’s second largest economy but also its second or third largest stock market by market cap — placing just before or after Japan. Its stock market includes over 3,500 listed firms that have a combined market capitalization of $7.5 trillion, according to a July 2018 paper by NYU finance professors Jennifer Carpenter and Robert Whitelaw and MIT financial economics Ph.D. candidate Fangzhou Lu. (The U.S. equity market capitalization is more than four times greater.)

“Since the wave of market reforms that started almost two decades ago, stock prices in China have become as informative about future firm profits as they are in the U.S.,” according to the authors.

Once the MSCI indexes increase their weightings in Chinese A shares, investors in passive and active funds benchmarked to those MSCI indexes will have more exposure to the Chinese market. More specifically, they will have increased exposure to Chinese companies that only  trade in China rather than to Chinese companies that trade in Hong Kong, such as China Mobile, or in the U.S, such as Alibaba, said Todd Rosenbluth, director of ETF and mutual fund research at CFRA.

BlackRock, whose international and global iShares ETFs are benchmarked to MSCI indexes, welcomed the MSCI announcement. “The gradual addition of onshore Chinese securities deepens the investment opportunity for global investors,” said Manish Mehta, BlackRock’s global head of markets and investments for iShares and index investing.

By attracting more foreign investors, the MSCI change could also potentially lead to changes in corporate governance of Chinese companies, said Stephen Tu, vice president and senior analyst for financial institutions at Moody’s Investors Service.

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