In focus - Markets
Eight charts that explain the growing importance of China A-shares
More and more international investors are turning their attention to the increasingly important China A shares market. Here’s why.
Unstructured Learning Time
As the world’s second largest economy, China’s significance to investors is more important than ever. Yet many international investors may not have the optimal balance of exposure to the country‘s stock opportunities.
Although China’s share of global GDP is close to 16%, the country is under-represented in major global stock indices. For example, in the MSCI All Country World Index, Chinese companies constitute less than 4% of the index.
However, this anomaly is changing and China’s principal market, where stocks are commonly known as A-shares, is gradually being included in major stock indices. To understand the opportunity, it’s helpful to understand the background.
The basics on China’s stock markets
Historically, foreign investors have been restricted from investing in China’s mainland stock markets, the Shanghai and Shenzhen stock exchanges. International investors have primarily gained exposure to Chinese stocks by investing in mainland China incorporated Chinese companies which are listed in Hong Kong SAR (Special Administrative Region) – commonly known as H-shares. There are 268 H-shares, including names such as China Construction Bank and Ping An Insurance Group, and in total these have a combined market value of around $761 billion, as at 5 September 2019.
Other common routes to investment have been through P-chips, Red-chips, N-chips, and B-shares.
- P-chips are those Hong-Kong listed companies not incorporated in China, but which derive the majority of their sales from mainland China, for example Tencent.
- Red-chips are Chinese state-owned enterprises, such as China Mobile. These stocks are incorporated outside of mainland China and listed in Hong Kong, but derive the majority of their revenue or assets from the mainland.
- N-chips are Chinese companies incorporated outside of China that are listed in the US as American Depositary Receipts (ADRs), such as Alibaba.
- B-shares are the stocks of Chinese companies listed in Shanghai or Shenzhen but denominated in a foreign currency. These are increasingly less relevant given the relatively smaller number of stocks in the universe.
But the game has changed dramatically. A-shares, which are companies listed and traded in the mainland stock markets, offer a far larger and more diverse opportunity for investors.
There are more than 3,600 A–shares companies, with listings in either Shanghai or Shenzhen. In market capitalisation, or value terms, China A-shares market is one of the world’s largest markets with a total value of $7,903 billion.
By comparison the New York Stock Exchange and the Nasdaq, have a market value of $28,124 billion and $12,310 billion respectively, as at 13 September 2019. Taken as a whole A-shares, H-shares, Red chips, P-chips and N-chips, the Chinese stock universe has a market value in excess of $10 trillion.
Chart 1: Ways to access Chinese companies
Source: CICC Strategy Research, data as at 5 September 2019
As these details highlight, investing in China’s stock markets can be complex. Given the difficulty of accessing the mainland markets in the past, the level of foreign ownership in China’s A-shares market is still low, at around 3%, relative to other emerging markets such as South Korea (32%) or Taiwan (40%). The key impediment has been accessibility, and restrictions have only been eased in recent years.
How China’s investment markets have opened up
China’s mainland stock markets had historically been difficult to access for foreign investors amid quota systems and capital controls. That was until the game-changing introduction of the Shanghai-HK and Shenzhen-HK Stock Connect programmes in 2014 and 2016 respectively.
The schemes allow international investors to access mainland listed stocks through the Hong Kong stock exchange (Northbound investment). At the same time, they allow onshore investors in China to invest into the Hong Kong equity market (Southbound investment). Their introduction was critical in MSCI’s decision to include A shares in its indices.
The chart below shows how investment flows have increased since the introduction of the Stock Connect mechanism. The dip seen in 2019, is linked to trade-related uncertainty as the US-China trade dispute escalated.
Chart 2: The increased investment flows to China
Source: Wind, 12 September 2019
Why are A-shares coming into focus now?
A key reason why A-shares have been getting more attention is due to MSCI’s 2018 decision to include A-shares in its major indices, including the MSCI China, MSCI Emerging Markets and MSCI All Country World. Initially MSCI included just 5% of the market cap of 267 large cap A-shares that it deemed eligible in its indices.
In February of 2019, MSCI announced plans to increase this factor from 5% to 20% by November 2019.
This is taking place in a 3-step process, during which some large cap stocks listed on ChiNext, the Nasdaq-style board of the Shenzhen Stock Exchange, and China A Mid Cap shares will also be included. In addition, other index providers such as FTSE Russell have started phased implementation of some China A-shares in their global indices.
With only 20% of the China A shares universe set to be included in MSCI’s indices at the end of this year, there appears to be significant scope for this to increase over time.
Escalation in the US-China trade dispute overshadows this outlook somewhat. However, another key impediment is the foreign ownership limits imposed by Chinese regulators.
These limits cap the share of Chinese companies which foreign investors can hold, in many cases at 30% of a company’s market capitalisation. The willingness and speed at which the Chinese authorities raise these limits will also dictate the pace of future A-share inclusion in MSCI and other indices.
The chart below shows how the weight of China A-shares in the MSCI Emerging Markets Index will be increased by November. The final ring illustrates the potential impact of full China A-shares inclusion, which could see China’s total index weight (mainland and non-mainland listed Chinese stocks) rise to over 40% (from ~32% currently).
Chart 3: How China A-shares will be included by MSCI
Source: Schroders and MSCI, Data as at 4 September 2019
A more diverse universe for foreign investors
The chart and table below outline the different investment opportunities across China’s stock markets, from “A” to “P” as discussed earlier.
Importantly, the improved accessibility of China’s mainland stock markets means that the investment universe has become more diverse. More opportunities relating to the mainland economy are becoming available to international investors. In short, it is becoming easier to build a more balanced portfolio of Chinese stocks.
Chart 4: The diversity of China's markets
Source: CICC Strategy Research, data as at 5 September 2019
What are investors buying into?
While many international investors are already familiar with the non-mainland Chinese stock markets, it is important to recognise that this universe represents just a small part of the wider China stock universe. Indeed, the majority of China’s stock market capitalisation sits in the mainland A-shares market. The market cap of the A-shares market is almost $7 trillion compared to under $1 trillion each for H-shares and US-listed China ADRs, respectively, as at 5 September 2019.
The A-shares market includes over 3,500 stocks listed across the two exchanges. However, the majority of these stocks are small cap (under $2 billion in market capitalisation).
The market is extremely liquid and the average daily turnover ranks third only to NYSE/Nasdaq. But the largest participants in the market are retail investors who account for more than 80% of trading volume (compared to 23% for H-shares).
Because retail investors tend to have shorter time-horizons and can overreact to short-term news flow, the A-shares market can behave less rationally than other markets. It has also historically been more volatile.
Chart 5: Small caps dominate the A-shares market
Source: Wind, 10 September 2019
Chart 6: How retail investors dominate the A-shares market
Source: Wind and HK Stock Exchange, 18 September 2019
While the A-shares market is relatively immature and tends to be more volatile, what makes it most interesting is the diversity of companies on offer.
As the chart below highlights, investors can access companies in industries and sectors that are otherwise unavailable in the non-mainland Chinese stock markets. This includes sectors like consumer goods (home furnishing retail, housewares & specialities, homebuilding), consumer services (travel & leisure), consumer staples (distillers), industrial automation, media and broadcasting, and healthcare.
Many of these industries provide investors with exposure to the expected drivers of China’s future growth, which is increasingly being driven by consumption.
Chart 7: How China's markets break down by sector
Although opportunities in the A-shares market are attractive, investors need to tread cautiously.
China is an emerging stock market and with that comes emerging market risks. Corporate governance is generally lower across many of the companies. Accounting standards are not too different from international norms. However, the quality of disclosure can be poor – particularly with respect to transactions between related parties, which can often involve conflicts of interest. And given the centrally-led nature of the Chinese economy, the market can be subject to significant volatility due to often sudden or dramatic regulatory changes.
The opportunity for shrewd investors
The key opportunity for global investors is that with the breadth of the A-shares universe and the relative inefficiency of the market, active fund managers have a genuine opportunity to outperform the main indices.
In the A-share market, the dominance of retail investors, who are generally less focused on company fundamentals, has meant that stocks can often be significantly undervalued (and vice versa, stocks are often overvalued).
Limited coverage by sell-side brokers also adds to the information inefficiency in the market; one-third of the market is not covered by broker analysts at all.
For international investors, language can also be an obstacle. Relatively few - perhaps no more than 20 - A-shares companies regularly publish financial statements in English.
In short, the opportunity for stock-pickers with sufficient knowledge and on-the-ground resources to add value in the A-shares market is significant. This point is borne out by recent figures: the chart below shows that the median active fund manager in China A has been able to outperform the index (or generate “alpha”) in five of the last six years.
While the market will eventually become more efficient over time as more and more institutional and international investors enter the market, this change is likely to be gradual. Foreign ownership currently stands at just 3% and institutional investors account for just 18% of the market.
Chart 8: How active managers have performed over the past five years
Source: Schroders, Mercer and Morningstar, as at February 2019. The MSCI China A Mercer Peer Group Median is an average manager return among comparable China A-share funds. Past Performance is not a guide to future performance and may not be repeated.The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested. Exchange rate changes may cause the value of any overseas investments to rise or fall.
Holding the right balance of China exposure
Improved accessability to China’s onshore stock markets means that the landscape for international investors is changing. This is at a time when China’s relevance to the global economy continues to grow. Emerging market investors who manage money against a benchmark, such as the MSCI Emerging Markets Index, now have to actively choose not to allocate to A-shares should they wish. Previously they would have to actively choose to add exposure to a market that is not in their benchmark.
Whether A-shares, or indeed any other Chinese stocks, make suitable additions to a portfolio will depend on a range of factors. For international investors in general, however, Chinese stocks are likely to represent an increasing share of their stock allocations in the coming decade, and in our view warrant a long-term strategic holding. Within this China allocation, the proportion allocated to A-shares is likely to see the greatest increase.
- More of our emerging markets insights are available here, including Head of Greater China Equities Louisa Lo on Where next for China A-shares?