A new approach to investing in emerging markets
Gavin Ralston and Kristjan Mee propose a new way of investing in emerging markets to benefit from the opening up of China’s capital markets
Even though China is the world's second largest economy, Chinese stocks have historically been underrepresented in global benchmark indices. This is because for a long time China A-shares, stocks listed in mainland China, were difficult for foreign investors to access due to restrictions on capital flows. A major shift happened in 2014 with the introduction of the Shanghai-Hong Kong Stock Connect, which allows qualified foreign investors to trade eligible A-shares without the need for a local Chinese licence.
Index providers have taken notice of this liberalisation. Last year MSCI added A-shares to its suite of global benchmark indices. Initially, only 5% of the full market capitalisation of A-shares was included. However, MSCI recently announced that the inclusion factor would quadruple over the course of 2019, to reach 20%. Currently, A-shares are only around 0.8% of the MSCI Emerging Markets Index, but this could rise to more than 14% after full inclusion. Nonetheless, there is no clarity on when or if A-shares will be fully included.
As the weight of A-shares grows, investors will have to decide how to access this part of China’s equity universe, and how much to allocate to onshore equities. We believe that rather than waiting for index providers to raise the weighting, investors should consider a separate satellite A-shares allocation, in addition to a global emerging markets mandate. Such an allocation would allow investors to access a much larger portion of the A-shares market. The broader opportunity set is necessary to reap the benefits of the compelling characteristics of the A-shares market as listed below.
An inefficient market
The A-shares market is dominated by retail investors, who in 2018 accounted for 86% of the total trading volume. This has made the market volatile and susceptible to wild swings in sentiment. In late 2014, the CSI 300 Index started to rise fast. Hoping to jump on the bandwagon, retail investors began opening new stock trading accounts. At one point in 2015, more than 4 million new accounts were opened every week. Consequently, stock prices became detached from fundamentals, driven by speculation. Inevitably, the bubble burst in June 2015 and the index fell close to 50% over the following months.
Fertile ground for active managers
Given the inefficiencies, the A-shares market has been a fertile ground for active managers.
Over the last five years, the median China A-shares manager has been able to earn an annualised excess return of 6.3% after fees. This is an exceptional figure by global standards. Median excess returns have been close to zero or negative in most global equity categories over the same timeframe. The high level of potential alpha means that investors can earn good returns even if the market as a whole does not deliver.
The correlation argument
The A-shares market can also be an important source of portfolio diversification. Historically, the onshore MSCI China A Index has had half the correlation with global equities than the offshore MSCI China index. As the share of A-shares is gradually increasing in global benchmarks, the diversification benefit will decline over time as A-shares become more integrated with the global investing universe.
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