Written by John Lin, Alliance Bernstein

MSCI has announced that China A-shares will be included in its emerging-market (EM) index next year, as we anticipated. Now, global equity investors need to consider how to access the vast universe of stocks traded onshore in China.

ekidin / Pixabay

The decision on Tuesday by index provider MSCI was a watershed for equity investors around the world. China A-shares are the world’s second-largest stock market with a market capitalization of US$7.5 trillion. But their exclusion from key EM benchmarks meant that most investors simply had no way of investing and were restricted to the smaller pool of Chinese H-shares traded in Hong Kong or elsewhere.

Not anymore. By adding a small group of A-shares to the MSCI Emerging Markets Index, the door has officially been opened. The inclusion process demonstrates how MSCI has refined its approach to waking China’s giant equity market by adding only 222 stocks that are sourced under the Stock Connect regime, or over 40% of the total onshore market cap. That’s a relatively narrow universe of investible stocks, chosen from over 3,000 stocks traded onshore in China. Yet it’s a small but important first step towards improving the representation of the largest developing-world economy in the MSCI Emerging Markets Index.

What should investors do about A-share inclusion? Some may initially ignore the event, while others may consider adding a stand-alone A-share strategy. However, as China starts to dominate the EM index we believe investors should start rethinking the way they look at the broader EM equity universe.

Don’t Dismiss a Growing Opportunity

Investors who choose to ignore A-shares may be overlooking a longer-term opportunity. While it’s true that the shares chosen for initial inclusion are only a very small part of the larger EM Index, we expect the percentage of A-shares included in the index to significantly grow over time. So by ignoring A-shares today, you would be missing compelling investment opportunities and unique China themes. Examples include leading Chinese consumer brands, world-class industrial leaders and innovators that are poised to benefit from changing environmental policies.

The onshore China A-share market is very large and very liquid, but still maturing. Retail investors, who tend to follow popular trends instead of long-term earnings patterns, make up about 80% of daily turnover today. These conditions are ideal for active investors who can identify inefficiencies and long-term fundamental opportunities to generate attractive returns.

The Stand-Alone Approach

The sheer size of the A-shares market will surely compel some investors to seek a dedicated strategy, putting them in control of their China exposure. This may seem relatively easy to do using passive exchange-traded funds (ETFs). However, we think passive approaches can be extremely risky in any immature or inefficient market, including the A-shares market.

For example, from 2013 to 2015, the returns of a popular ETF fell short of the FTSE A50 Index of the 50 largest A-shares by more than 33%. The ETF was tracking the benchmark using derivatives, which became illiquid as a result of regulatory changes. In our view, stand-alone active portfolios backed by solid research can stay in tune with rapid regulatory changes to avoid these types of pitfall.

Of course, active investors must also be mindful of risks in the A-shares market. In particular, when allocating to a stand-alone A-share strategy, investors need to make sure they aren’t unintentionally doubling up exposures in an EM portfolio, especially as China’s weight in EM indices grows.

Dividing the Emerging Universe

China would account for about 40% of the MSCI EM Index after full inclusion of the combined A-shares and H-shares markets, according to MSCI data from March 2016. A broad market index loses its diversification benefits when it becomes so heavily dominated by one country.

That’s why we think investors should start thinking about the EM equity universe in two parts: All China and EM ex China. We believe that the market will evolve along these lines in the wake of the MSCI decision. Dividing the EM universe like this offers the best way to capture the opportunities and themes in Chinese equities and allows investors to maintain exposure to a diversified basket of EM countries.

While MSCI’s decision has captured big news headlines, it’s really just a first step to opening up Chinese stocks to investors around the world. In our view, MSCI will ultimately include the entire A-share market into its indices. While we don’t know what the timetable will be for further moves, we believe investors who think strategically about how to access the evolving China opportunity today can gain a clear advantage in improving returns from their global and EM equity allocations tomorrow.