Kate Marshall, Senior Investment Analyst 31 July 2019
China’s one of the world's fastest-growing markets.
As its economy has grown, so has the number of Chinese companies. The opportunities for investors have expanded at a phenomenal rate.
In the past, it's been difficult for most overseas investors to get exposure to China because of its rules on foreign investment. But things are changing.
This year, MSCI, the stock market index provider, will increase the number of China A-shares in its emerging markets index from 239 to 421. The shares will represent 20% of the broader A-share market, up from 5% currently.
It's an important milestone. MSCI is hugely influential in where investors' savings go across the globe. Thousands of passive funds copy the makeup of their indices, and lots of active fund managers use them to measure performance.
What are China A-shares and why are they restricted?
China A-shares trade in mainland China, on the Shanghai or Shenzhen stock exchanges.
MSCI has previously held back from adding these shares to its flagship emerging markets index for several reasons.
For a start, they've historically been restricted to domestic investors. It means the market's dominated by private, local investors, which account for 80% of market trading. These smaller investors often borrow money to invest, tend to be speculative, and have a short-term mind-set. This higher frequency of trading is one of the reasons the market can be so volatile.
The market's also heavily influenced and directed by the government, which has previously been criticised for the way it's intervened in trading.
But it's worth noting much of the A-share market is still young, especially compared with more established developed markets like the UK's FTSE All-Share. There are still improvements to be made, but China is gradually taking steps to open its markets to foreign investors.
In 2002, for example, a scheme was set up to allow larger investors, like fund managers, to invest in domestic companies. This was subject to strict rules and limits though.
The step-change came in 2014, when the Stock Connect programme launched. It provides a link between the onshore Shanghai and offshore Hong Kong stock markets, and lets foreign investors trade selected A-shares with fewer restrictions. The Shenzhen-Hong Kong Stock Connect followed in 2016.
What does this mean for investors?
China currently makes up 31% of the MSCI Emerging Markets Index, and most emerging markets funds already have some exposure to the world’s second-largest economy. This allocation is mainly made up of Chinese companies that are listed on overseas markets though, including Hong Kong, while some well-known names, including large tech firms like Alibaba and Tencent, are listed in the US.
The A-share market includes a much broader set of opportunities. There are over 3,500 companies listed on the market compared with 1,200 that are listed overseas.
The market provides exposure to a big range of sectors too. At the moment the China portion of the MSCI Emerging Markets Index is focused on large internet companies, banks, and state-owned enterprises (businesses that are partially or majority owned by the government).
The A-share market is much more domestically focused and home to sectors that are exclusive to it, such as homebuilding, home furnishing retailers, and general merchandise stores. Overall it's considered to be more reflective of the underlying Chinese economy.
It also includes more small and medium-sized companies, so there's opportunity for investors prepared to take on more risk in their hunt for potentially greater long-term returns.
Too big not to invest?
China's markets have evolved significantly over the years, in terms of both the quantity and quality of companies. Its markets are now simply too big to be overlooked by investors, especially if the country continues to prosper, make investor-friendly reform and improve corporate governance.
China A-shares will make up 3.3% of the emerging markets index once the inclusion is complete. It might not sound much, but now the ball is rolling there's scope for more to be added in future. Their inclusion marks the size and significance of China's market on a global scale, and shows the willingness of Chinese authorities to bring their markets in line with others.
It has wider implications for investors too – if you buy a passive fund that tracks the MSCI indices, you'll now have more invested in A-shares. Active funds that use the MSCI index as a benchmark may also consider A-shares investment. This will bring international attention and investment.
There's still work to be done though. China still needs to align itself with worldwide trading standards in order for more companies to be included. There are other wider concerns too, including slower economic growth and a mounting debt pile.
How can you invest?
Investing in a single emerging market country, such as China, is a specialist and high-risk way to invest.
We think investing in a broader Asian or emerging markets fund is a good starting point for most portfolios. This way the decision over how much to invest in different countries is left to a professional.
We like Aberdeen Asia Pacific Equity as a way to invest in a range of Asian companies. Around a quarter of the fund invests in China at the moment, 4.5% of which is invested in A-shares. The team behind the fund think they're a great way to take advantage of growing consumption in China, and it's possible this part of the fund could grow over the years.
For those able to take on more risk, Fidelity China Special Situations offers a way to get pure exposure to China. It's run by Dale Nicholls – he invests in companies he thinks can profit from the surge in China’s middle class. They include technology giants like Alibaba and Tencent. But lots are higher-risk small and medium-sized companies, as that’s where he sees the best opportunities for growth. He normally avoids banks and large government-owned enterprises, which make up a big part of the Chinese stock market, so the trust can perform differently to the market.
He uses gearing (borrowing to invest), and has the flexibility to use derivatives, and these increase risk too. We think this type of investment trust should only make up a small part of a well-diversified portfolio.
Alternatively, passive funds offer well-diversified exposure across the entire emerging markets. Our choice is the iShares Emerging Markets Equity Index Fund, which aims to track the performance of the FTSE Emerging Index. One third of the fund currently invests in China – it doesn’t have much in A-shares at the moment, but this could change over time.
This article isn’t personal advice. If you’re not sure an investment is right for you, take advice. Investments will rise and fall in value so you could get back less than you put in.
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