Index Changes To FTSE China 25 ETF Are Good

FXI is doing more than doubling the number of its holdings—it’s about to become a better China fund.

On Sept. 22, the FTSE China 25 Index, a cap-weighted index of the 25 largest Chinese companies traded in Hong Kong, will officially begin its migration to become the FTSE China 50 Index.

This is a big deal, because the FTSE China 25 Index is perhaps the most successful and widely followed China index in the world. The index has roughly $7.5 billion in ETF assets tied to it globally, including $5.9 billion from the U.S.-listed iShares China Large Cap ETF (FXI | B-49).

Since its creation in the early 2000s, the index has become somewhat of a barometer for China’s equity market to global investors outside of China.

I’ve been writing about China’s evolving markets and the need for investors to rethink their China exposure. I think FTSE’s decision to “enhance” its most successful China index is a sign of the evolving Chinese equities landscape.

I recently had a chance to catch up with Jamie Perrett, director of index research at FTSE, who was originally involved in the creation of the FTSE China 25 Index.

He summed up the migration by saying “China’s evolved, and continues to evolve. Since the creation of the index in 2001, the eligible universe for the FTSE China 25 has doubled, and the index needs to take that into account.”

Perrett also mentioned significant discussions and feedback from index users as a reason behind their decision to make the migration.

The New Index Migration Process

As the new index name suggests, the new FTSE China 50 Index will hold the 50 largest Chinese companies listed in Hong Kong.

While the index will double the number of holdings from 25 to 50, the additional 25 securities are only expected to contribute about 20 percent of the new index’s market cap. After all, the index is cap-weighted, so the top 25 securities should naturally continue to make up the lion’s share of the index’s market cap.

Still, the migration will significantly change the sector composition of the index.

According to FTSE, the change will decrease the index’s massive concentration in financials by almost 10 percentage points, from the current 56 to 46 percent. Meanwhile, the consumer sectors are expected to get a bump up in weighting by roughly 5 percentage points.

The migration will take place over the course of two months and three “migration reviews” to avoid impacting the underlying markets and minimize overnight turnover.

On Sept. 22, the index will adjust a third of the current constituent’s weighting, as well as add a third of the weighting of new constituents. This will be followed by a similar process in October, and conclude the full changes on Nov. 24.

Not The Index’s First Major Change

While there’s been significant press coverage of this upcoming change, this is hardly the index’s first major change.

FTSE’s reclassification of “P-chips” from Hong Kong to China in March 2013 already had a major impact on the index’s composition and performance over the past year.

FTSE defines P-chips as companies controlled by mainland individuals but incorporated outside the mainland, traded in Hong Kong and deriving a majority of revenues from mainland China. (For details on China share classes, see our 2014 China ETF Guide.)

While only a handful of P-chips entered the index after March 2013, the biggest of them all, Tencent Holdings, happens to be one of China’s largest Internet companies.

Tencent, together with Baidu and Alibaba, make up the “Big Three” China Internet companies, which collectively are increasingly being referred to as “BATs” in the media.

Tencent is now the largest holding in the FTSE China 25 Index, grabbing 10 percent of the index’s weighting. Chinese Internet companies have had a banner year, and Tencent returned a staggering 67 percent over the past year.

Here’s a table of sector changes immediately after the inclusion of P-chips (keep in mind this is as of March 2013), and how the sectors are expected to look after the full migration to the FTSE China 50 Index.

Source: FTSE

The Takeaway

The way I see it, the FTSE China 25 Index migration to 50 constituents is a change for the better that investors should be embracing.

Adding 25 new securities should only diversify the index’s sector exposure into more entrepreneurial companies and away from state-owned enterprises dominating the financial sector.

As a whole, FTSE is also evolving within the China space by tackling the A-share conundrum. A-shares are tricky because they’re still restricted to global investors, yet through various quota programs, they’re fully available to investors through ETFs.

Instead of forcing investors to wait years for the eventual inclusion of A-shares into their standard global indexes, in June, it launched its FTSE Global R/QFII Index Series. These customizable indexes put the decision of A-share inclusion into the hands of its investors.

China’s equity market has changed significantly over the past decade, and will continue to evolve. I commend FTSE for making the necessary enhancements to capture China’s evolving market.

At the time this article was written, the author held no positions in the securities mentioned. Contact Dennis Hudachek at [email protected], or follow him on Twitter @Dennis_Hudachek.