In our view, China is simply too big to ignore and too great an investment opportunity to miss, so it could be time for investors to consider adding a separate, specific allocation to their portfolio. But the market is notoriously hard to navigate. Chan Samadder, Head of Product and Sales Strategy at Lyxor, has the solution.
China's lengthy transition towards a consumer-led economy and the likelihood of higher current account deficits demands greater capital inflows from foreign investors. The People's Republic has made significant progress in opening-up its economy and liberalising its markets over the past two decades, but more is needed. The Chinese equity market remains vastly underrepresented in global indices despite its size. About two thirds of the equity value in Chinese companies is still not available for trading, which contrasts sharply with the US stock market. Capital restrictions and state ownership remain the two major hurdles for the freer flow of capital.
Tackling some tricky trade-offs
Mainland companies have had no choice but to navigate a variety of trade-offs in determining where they should legally incorporate and where they should publicly list their equity. As a result, Chinese companies currently trade in five different currencies on seven exchanges.
Many Chinese companies incorporate or list their shares overseas for a number of reasons (e.g. lower tax rates, favourable regulation…). While H shares have been strongly represented in Chinese stock indices, they are heavily weighted towards financials and are not fully representative of China's public markets. The Chinese government remains a major shareholder and large portions of companies' stock are still not eligible for trading.
A more retail market
The Chinese equity markets differ greatly from those elsewhere. Retail investors own most of the listed shares on the mainland so there is a much higher turnover in portfolios than we'd see among longer-term, institutional investors. Furthermore, equities only represent a small portion of their wealth. Households are mainly invested in property, wealth management products, and bank deposits. Stock financing is also small for Chinese corporates as opposed to bank loans and retained earnings. As a result, Chinese corporates are less sensitive to market gyrations than their developed world peers.
China's Shanghai Composite Index meanwhile is dominated by state-owned companies - each of the top ten valued companies are SOEs (state-owned enterprises) for example. The Communist Party floats only a small percentage of a company's equity on the stock exchange while keeping control of the rest. Therefore, a core part of valuations cannot be truly factored in to the company's stock price. Share prices may well be a reflection of market liquidity and demand rather than corporate value.
Opening-up to foreign investors
In an early effort to open the local market to foreign institutional investors, China introduced quota programmes in 2002 (QFII) and in 2011 (RQFII). These programmes eventually allowed asset managers to list international ETFs with exposure to mainland China securities. Then, in 2014, the authorities introduced the Shanghai Hong Kong Stock Connect, giving investors the ability to buy and sell Shanghai-listed stocks without prior approval from China's regulatory bodies via a brokerage account in Hong Kong. The Shenzhen Hong Kong Stock Connect was launched a couple of years later. Finally, MSCI started introducing A shares into their Global Standard Indexes starting in June 2018.
Staying with MSCI, the bellwether EM index provider recently announced it will quadruple the weight of securities from the MSCI China A Inclusion Index in their Global Standard Indexes from 5% to 20% in three tranches, starting at the end of May and concluding in November. On top of adding 253 large-cap China A shares, MSCI will expand its coverage to include 168 medium-sized corporates for the first time. The inclusion of 27 stocks from ChiNext is also a sign of further diversification in the future, with the addition of securities from growth sectors such as IT and healthcare.
Source: MSCI, data as at 22 January 2019. All figures are approximate.
Eventually, full inclusion will lead to a total China exposure of 40% in the MSCI Emerging Markets Index.
Source: MSCI, data as at 22 January 2019. All figures are approximate
For onshore exposure, our China A ETF is ahead of its time
By November, MSCI's 3-step inclusion process will be complete. Large-cap China A shares will have reached a weighting of 20%, as will China A mid-caps.
That's why we took the opportunity to switch the index of our physically replicated China A shares ETF from the MSCI China A Onshore Net Total Return Index to the new MSCI China A Net Total Return Index in March. We believe this index is the best reflection of how any future China A Shares index building block will look post November 2019.
Unlike the MSCI China A Inclusion Index - which is built to evolve sequentially in line with MSCI's inclusion timeline - our index accounts for all of the inclusions immediately, so it should benefit from the inflows we expect to see into A shares in the lead up to November. Our ETF is also the first in the market to include the mid-cap A Shares and is, in our view, the most representative of the full China A opportunity set.
Source: Lyxor International Asset Management, April 2019. For illustrative purposes only. This is not a recommendation. *Competitor ETFs refer to ETF providers in Europe offering products tracking the MSCI China A inclusion index.
Why choose Lyxor's Chinese ETFs
1Source for all data unless otherwise indicated: Lyxor international Asset Management, Bloomberg, data as at 26/03/2019. *TER correct as of 01/05/2019.
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