Everyone wants to cash in on the great gold rush of the 21st century - the China boom - and that includes indexers. Every month, it seems, some indexer launches a new product aimed at U.S. investors tracking the performance of the Chinese market. A few brave firms - particularly Dow Jones - have even formed joint ventures with Chinese partners, looking to make headway in the domestic Chinese market.
MSCI did those braves souls one better on May 10, announcing a major new go-it-alone initiative in China. The company launched a new "A-Share" index targeted at domestic Chinese investors and laid out plans to open an office in Shanghai.
"China is one of the world's fastest growing economies and a large emerging market," said Ken O'Keeffe, executive director in product management at MSCI. "We're very excited about this opportunity."
They better be, because the Chinese market is notoriously difficult place for outside firms to succeed. MSCI does have a leg up, however, thanks to its 2004 merger with Barra. Barra has a portfolio analytics tool already on the market in China, with a couple dozen clients and a growing reputation. Leveraging those relationships could be central to MSCI's success.
Leading With An Index
The core of MSCI's push, however, will be its new A share index. The MSCI China A Index debuted on May 10 following what MSCI described as "extensive" consultations with clients on the ground. Although it is not the first index targeted at domestic Chinese investors, the new A share index does try to distinguish itself with a unique methodology adapted to China's evolving capital markets.
"Its main point of difference from competing indices is that it's the first investable A-share index built by from the bottom up by industry group," said O'Keeffe.
As O'Keeffe explained, MSCI's believes that traditional indexing techniques - like straight market capitalization weighting systems - don't work in China, because the Chinese market is so different from those in the West. For instance, most Western equity markets are dominated by a handful of large cap names, while the Chinese market is "flat," with a lot of mid cap companies. In the United States, the top 10 percent of companies make up over 80 percent of the market capitalization; in China, the top ten percent account for just 35 percent of the market.
"The Chinese market is a very flat market by market capitalization, and it's changing very rapidly," said O'Keeffe. "Small changes in market capitalization can lead to big changes in the ranking of different companies."
That problem is exacerbated by the huge number of initial public offerings in China, where fully 25 percent of the total market capitalization has come public within the last four years
"You can't use a narrow index that just selects the largest securities, because it would lead to too much turnover," said O'Keeffe.
At the same time, simply capturing all of the securities in the market isn't practical, because many of them are too small or illiquid to be investable.
MSCI's solution was to use what it calls a "bottoms up sector based approach." To do that, MSCI studied what the market would have looked like if you created an index of all 1,377 publicly traded companies. Then, the company created an index of investable names matching the sector weights of that hypothetical "complete index." (The investability screens include all the regular requirements: free float weighting, minimum free float, minimum market cap, etc.).
The result is an index that more-or-less reflects the true sector breakdown of the Chinese market, and one with relatively little turnover. MSCI's research suggests that its index also closely tracks the performance of the hypothetical "complete index."
Whether or not this unique indexing methodology catches on in the marketplace is still up in the air. Nonetheless, it represents an interesting attempt to innovate and look beyond traditional indexing to tackle the unique issues surrounding the Chinese marketplace.
The Chinese Market Is In Its Infancy
One thing to keep in mind is that the Chinese indexing market is in its infancy - particularly from the investing point of view. MSCI sees the index being adopted first for research, benchmarking and asset allocation purposes, with the potential for investable products somewhere down the line.
"Indexing and passive management is not well accepted in the Chinese marketplace yet, where the emphasis is on active management," said O'Keeffe. "But maybe down the line…"
 . For those unfamiliar with Chinese equity markets, there are different classes of shares for different types of investors. "A shares" are denominated in local currency, and are targeted largely at local investors; "B shares" are valued in foreign currencies and available to select foreign investors; "H shares" are listed in Hong Kong and available to everyone.