Coming To An ETF Near You: China A-Shares

After years of anticipation, MSCI has finally taken the plunge. Today the index provider followed through on its promise to add China A-shares to its indices, opening the door for billions of dollars of foreign capital to flow into mainland Chinese stocks.

A-shares are stocks of Chinese companies that are incorporated on the mainland. They trade in Shanghai or Shenzhen and are quoted in renminbi. That’s in contrast to other China share classes, which are made up of stocks of Chinese companies that may or may not be incorporated on the mainland and that trade in Hong Kong or the U.S. Most of those other China share classes, such as H-shares and N-shares, are already included in MSCI indices.

With today’s MSCI move, 230 China large-cap A-shares will be added to the MSCI China Index, the MSCI Emerging Markets Index and the MSCI ACWI Index. As outlined in MSCI’s decision last June, initially, A-shares will be significantly underweighted in the indices—only 5% of their market cap will be used to calculate weightings—with 2.5% being added today and the other 2.5% coming on Sept. 3.

Market Impact
While certainly symbolic, the question now is whether such a modest inclusion of A-shares into MSCI indices is impactful for investors.

Any funds that track the affected MSCI indices will have to buy A-shares to stay in line with the index’s performance. That includes ETFs such as the $49.8 billion iShares Core MSCI Emerging Markets ETF (IEMG) and the $39.3 billion iShares MSCI Emerging Markets ETF (EEM). Active funds benchmarked to the MSCI indices may also be pressured to buy A-shares.

According to a recent report from MSCI, this first phase alone of A-shares inclusion could spark inflows of $22 billion into those stocks. That may sound like a lot, but it’s relatively small compared to the $8 trillion total market capitalization of the A-shares market, which is essentially the second-largest market in the world after the roughly $30 trillion U.S. market.

That may be why mainland Chinese stocks haven’t seen much of a pop from the MSCI news. The $690 million Xtrackers Harvest CSI 300 China A-Shares ETF (ASHR), a fund that exclusively holds A-shares, is down 5.6% year-to-date—though it is up 13.2% since last June, when MSCI first made its intentions to add A-shares to its indices known.

If the index provider eventually greenlights full inclusion for A-shares, a hefty $300 billion could flow into those stocks, according to Reuters. That’s something that could light a fire under mainland stocks and the ETFs that track them.

Weighting To Grow Slowly

Aside from the effect on A-shares themselves, the other area of impact for investors is in the makeup of funds that track MSCI’s indices, especially the MSCI Emerging Markets Index.

Chin Ping Chia, head of research for Asia-Pacific at MSCI, says the initial inclusion of A-shares into the MSCI Emerging Markets Index will only increase China’s proportion of the index by 0.8% to a 31.3% weighting.

However, if China continues to liberalize its markets and MSCI greenlights further A-shares inclusion for its indices, China’s weighting in the Emerging Markets Index could jump significantly. Chia says that if full inclusion of the 3,000+ A-shares companies were to happen, China could account for 42% of the index, with A-shares alone accounting for 16%. If A-shares midcaps were also added, China could make up almost 50% of the index, Chia notes.

Full inclusion of China A-shares into MSCI indices won’t come immediately. Outstanding concerns about weak corporate governance, trading suspensions and other issues make it so the route to full inclusion will likely be a gradual process.

“We don’t know how many years [a full inclusion] could take. But it will be a multistep process,” said MSCI President Baer Pettit. “But the next step will come quickly; probably in the second half of this year.”

Growing Exposure

Regardless of the timetable for full inclusion, the key for investors is understanding that their emerging market fund—whether it be IEMG, EEM or another fund tied to the MSCI Emerging Markets Index—could see a significant jump in its exposure to China.

That increasing concentration in China is an important consideration for investors. Some see it as a positive development. Vanguard, the company behind the largest emerging market ETF, the $66 billion Vanguard FTSE Emerging Markets ETF (VWO), says that A-shares inclusion actually increases diversification for investors.

VWO began offering exposure to China A-shares in 2015 and has been steadily increasing that exposure as China opens up its market to foreign investors—which is essentially the blueprint for what will now happen with IEMG, EEM and other funds tracking MSCI indices.

Adding A-shares “provides a more accurate reflection of the Chinese market. The Chinese market is not fully open to foreign investment, but to the degree that it is, an emerging markets index and products that track it should reflect that,” said Rich Powers, head of ETF product management at Vanguard.

“The world we can access is getting broader, while the costs to invest are getting lower. Why not increase exposure to that? We believe that diversification reduces risk per unit of return,” he explained.

More Concentration, More Risks

On the other hand, there are those who believe more exposure to China—and especially A-shares— equals more risk.

"Beijing has shown a very strong inclination to make sure they control the financial markets," Christopher Balding, associate professor of business and economics at HSBC Business School in Shenzhen, told the Nikkei Asian Review. "It is not a problem until it becomes a problem. You either play by the rules, or you go away."

Meanwhile, others say China is simply becoming too big a concentration in indices like the MSCI Emerging Markets Index.

“The concentration issue really is going to get worse as you start to include more of China in there,” Jay Jacobs, director of research at Global X Funds, told CNBC. “People looking for that growth really need to shift their line of sight further down the developing-market spectrum.”

Investors concerned about concentration could look to emerging market funds that limit their China exposure, or build their own emerging market portfolio using single-country funds.

Email Sumit Roy at [email protected] or follow him on Twitter sumitroy2