Asset managers have welcomed index compiler MSCI’s decision to add more China A-shares to its benchmark indices.

The inclusion, which will take place in three steps, means the number of A-shares in the benchmark emerging market index will quadruple to 20 per cent by November, from 5 per cent today.

The MSCI Emerging Market index’s pro-forma weighting to Chinese A-shares will rise from 0.7 per cent to 3.3 per cent.

The decision was largely in line with MSCI’s previously outlined plan, but came in slightly ahead of market expectations.

Growing optimism about the prospects for a US-China trade agreement, when US President Trump and China President Xi-Jinping next meet in mid-March, may at least partially explain the earlier timeframe.

"Chinese equities have recovered over the first two months of 2019, as investors have been expecting a positive outcome of the Sino-US trade negotiations," says Fidelity's Catherine Yeung.

The S&P 500 and the Dow Jones Industrial Average snapped a three-day run of losses on Friday, as optimism about the prospects for a US-China trade agreement countered downbeat US and China manufacturing data.

Friday marked the first close above 2,800 for the S&P since 8 November.

Anticipation of a trade deal between these two countries has also underpinned sentiment, says Yeung. She points to  the inclusion of mid-caps from November as somewhat unexpected in this latest announcement, having previously been slated to occur only from 2020.

 

"Simultaneously, the Chinese government has continued to act on its intention to support Chinese corporates' access to funding to support domestic economic activity.

"It also highlights China’s growing significance in the global financial markets, in line with its significance as a global economic leader," she says.

"Net-net, this is positive for sentiment and also increases the likelihood for listed A-share futures in Hong Kong."

Shares listed on the tech-heavy large-cap ChiNext exchange will join the index for the first time in May.

Investment bank UBS estimates the domestic Chinese stock market will see inflows of US$67 billion in 2019 alone. Even larger inflows should follow next year.

MSCI indicated the weight of A-shares may increase in future if China continues to promote the further opening and development of the market through permitting the listing of index futures and other derivatives on onshore and offshore exchanges.

A further boost to the A-shares market will come when FTSE Russell, another index provider, begins to include them in its indices from June 2019.

Data from the People’s Bank of China show foreign investors held 1.15 trillion Chinese yuan (£129 billion) in A-shares as at the end of 2018. That’s the equivalent of 6.7% of A-share free-float market capitalisation, up from 2.3% in November 2015.

Further, in the year-to-date there has already been 121 billion yuan of inflows through the Shanghai-Hong Kong Stock Connect. UBS analysts note that foreign investors as a group have now surpassed insurers as the largest A-share holder. This MSCI weight increase means they’ll soon be challenging domestic mutual funds, which are currently the largest player in the market.

“Although full inclusion may take years based on Korea and Taiwan’s experiences, we expect the largely retail-driven A-shares market to become more institutionalised over time,” add UBS’s analysts.

Boost to corporate governance?

For the market in general and companies more specifically, the news seems to be positive. As Eric Moffett, manager of the T. Rowe Price Asian Opportunities Equity fund, foreign institutional investors tend to take a longer-term, more fundamentals-based approach to investing than some sentiment-driven domestic retail investors.

This should, in turn, help to bolster corporate governance, adds Moffett, as local companies begin to increase the transparency of reporting practises and adopt strategies that more firmly consider shareholders’ interests.

In terms of the average quality of companies, the A-Shares market is “probably the worst-quality market in the Asian region”, claims Robert Horrocks, chief investment officer at Matthews Asia.

However, due to the sheer volume of companies listed, it’s also “the place where you have the chance to find the largest number of decent quality businesses”.

Even stripping out the worst third of the market, there are at least a thousand other companies that warrant a closer examination, he explains. Of them, there are probably 200-300 that warrant regular analysis and research.

“Certainly, can you put together a quality portfolio of 50-60 companies out of the A-Shares market that can grow sustainable over time? Yes, you can.”

There are some clear attractions for A-shares and it’s an area fund managers who invest in China already are positioning themselves.

For starters, says Qi, they provide exposure to a more diverse range of sectors and companies than H-Shares. Two themes in particular stand out: consumer and healthcare. These areas can benefit from China’s long-term demographic and structural trends.

Further, she adds: “A-shares also have had a lower-correlation with offshore markets than other emerging markets, thus providing a better risk diversification profile.”

While short-term pressure, which include uncertain monetary policy and potential trade wars, may supress returns from Chinese equities through this year, “China’s A-shares look like a good place to be looking for long-term returns”, says Horrocks.

UBS expects consumer-related sectors to disproportionately benefit from an influx of foreign investors into the market. That’s because they seem to value the steadier growth in China’s consumption more than investments and exports.

Its dozen-strong list of high-conviction ‘buy’-rated stocks include six consumer and healthcare names. High-end liquor distiller Luzhou Laojiao, home appliances seller Qingdao Haier and innovative drug maker Hengrui Medicine feature.

Financials like China Construction Bank and Ping An Insurance are high up on the list, too.