We recently wrote that China is trying to light a fire under its stock market by loosening the rules for investing with borrowed money. And now there’s another reason for Chinese shares to catch fire.
MSCI (which stands for Morgan Stanley Capital International) is one of the top providers of indices for emerging markets. These indices are tracked by fund and investment companies to help them build emerging market portfolios.
For instance, if you own an emerging markets unit trust or investment fund, chances are good that it uses the MSCI Emerging Markets index as a benchmark. Most actively managed funds pretty much just copy the index (by investing in the companies that form part of the index) without admitting it.
Other investment products, like exchange traded funds (ETFs) or index funds, are designed to copy the index exactly.
So, when MSCI makes a change to an index, literally trillions of dollars’ worth of investment funds copy what they do. That means that billions of dollars’ worth of stocks are bought and sold based on the decisions MSCI makes about its indices. That’s enough money to have a major effect on a share’s, or market’s, price.
One odd thing about the MSCI Emerging Markets index is that it does not include stocks that trade on mainland China stock exchanges, like Shanghai and Shenzhen. These are also known as “A shares.” (Chinese company shares that trade in Hong Kong are “H shares.” Chinese shares that trade in Singapore are “S shares.”)
This is strange because China is the world’s largest emerging market. It is worth about US$7 trillion and accounts for about 10 percent of the total world stock market value. On the basis of relative size, Chinese shares should be the biggest part of the MSCI Emerging Markets index. But they’re not included yet (more on why in a moment).
That’s not to say the index has no exposure to China at all. As of the end of February, Chinese companies made up over 24 percent of the index – that’s more than any other country.
But the shares used for the China portion of the index are not traded in mainland China. They are mostly traded in Hong Kong or the U.S.
The reason that MSCI uses Hong Kong and U.S.-listed Chinese companies is because it’s easier and more popular with big investment funds. It’s easier for non-Chinese investment companies to buy and sell Hong Kong-listed shares than shares that trade in Shanghai.
And after what happened last summer – when the Chinese government suspended trading and changed some of the market rules to stop the market’s slide – some big investors are worried about putting too much money in the mainland’s stock market.
One of the big concerns is whether investors would be able to get their money out if there was another stock market crisis. Or, because of current quotas that limit how much foreign investors can invest in Chinese stock markets, if they would be able to invest anything to start with.
Because of this, MSCI said last summer that China A shares would not be included in any of their indices. But late last month, they appeared to have reconsidered. And if a change happens, it would begin to be implemented by June.
The decision process was outlined in what they called their “inclusion roadmap.” In it, MSCI explained why they’re thinking about including China A shares.
MSCI said: “The reopening of the consultation follows the recently implemented changes by the Chinese authorities aimed at enhancing the accessibility of the China A shares market for international institutional investors.”
In other words, China is now saying they will make it easier for big, foreign investment funds and other investors to buy and sell shares listed in Shanghai or Shenzhen.
As a result, MSCI is thinking of making 1.1 percent of their Emerging Market index China mainland-listed shares. That may not sound like a lot, but funds that manage about US$1.5 trillion dollars in assets track this index.
That means over US$16 billion worth of mainland-listed shares would have to be purchased for these investment funds to track what MSCI will do. Relative to the total value of shares traded every day, it’s not that much to start with.
But that would just be the beginning. If it becomes easier and easier for foreigners to buy China-listed shares, the MSCI Emerging Market index’s exposure to China A shares could rise.
For example, imagine if MSCI said the 24 percent exposure to China the index already has was to eventually be made up entirely of China A shares. That would mean about US$360 billion worth of China A shares would have to be purchased.
And that’s just using one index provider, MSCI, as an example. If other index providers like FTSE and Standard & Poor’s (S&P) also change their minds about China A shares, even more money will flow into mainland exchanges.
This could take years to happen. But as the process unfolds, it will provide continued buying interest in China A shares.
If you would like to get exposure to this, try an ETF. A very popular one that trades on the Hong Kong exchange is the iShares FTSE A50 China Index (Hong Kong; code:2823). This tracks the performance of fifty of the largest Chinese companies that trade on the Shanghai or Shenzhen exchange. The ETF doesn’t own the shares, but it uses derivatives to mimic how those shares perform.
Singapore has the United SSE50 China ETF (Singapore; code: JK8), which also tracks 50 of the largest China A shares. The trading volume for it is pretty low, so be careful when you buy and sell it.
And if you would like to buy China A shares in the U.S., you can use the Morgan Stanley China A Shares fund (New York; ticker: CAF). This is a closed-end fund, so it holds a basket of China A shares like an ETF but there were a limited number of shares issued when the fund started, and you can buy shares of it on the stock exchange.