Major Changes Coming for Chinese stocks

I wrote in November about the major changes in the structure of the Chinese capital markets. The “stock connect” made Chinese onshore “A shares” more accessible to investors and opened up a new flow of demand.  Since then the ETF which invests in A shares ASHR has risen since then and Chinese stocks have had a huge rally this year.

 The A shares  ETF ASHR is up 83% since the initiating of stock connect last November (chart below) MCHI the ETF based on the current MSCI china index is up 26.6%

I have observed in the past that the “economic footprint” of many countries is far larger (% of world GDP) than their weight in market capitalization indices. This is because the indices reflect the number of publicly traded companies in those markets. China is currently 15.4% of world GDP but only 2.95% of the MSCI global stock index.

 Further complicating the weighting of Chines stocks in indices is the different classes of Chinese shares. Among them A shares which trade on the mainland (and became more widely available through stock connect.) H shares traded in Hong Kong and N shares traded in the US market (like the recently publicly issued Alibaba).

Up until now the most widely used indices for emerging markets the MSCI index and the FTSE Russell indicess have not included N or A shares.

The same is the case for ETF MCHI based on the MSCI China index.

This change can potentially produce significant increase in demand. The reconstruction of most indices impacts market prices although usually before the actual date when the reconstruction takes place.

One of the 2 major index providers FTSE Russell has just announced a transitional index to include Chinese A shares. which will make up 5% of the index 

As the article notes:
When and how to include China A shares - yuan-denominated shares listed on the Shanghai and Shenzhen stock markets - has been a major challenge facing global index providers. Inclusion in benchmark indexes could pour billions of dollars into China stocks over time.

Over time the impact of the changes in the index will be dramatic:

The indexes will be called FTSE Emerging inclusion indexes, and will have an initial weighting of 5 percent for China A shares. That will rise to 32 percent when the shares become fully available to international investors.

When taken together with other types of China shares including those listed in Hong Kong, Chinese shares would then account for 50 percent of the emerging markets index, FTSE Russelll said.

The much larger index provider.. MSCI is making changes in its treatment of Chinese stocks as well. Currently only Chinese shares traded in Hong Kong (H shares) are included in the index.

The inclusion of the N shares will take place in 2015. An announcement on the inclusion of A shares will take place on June 9 and would likely take place in 2016. Either of these changes will be implemented gradually to lessen the impact on trading.

The addition of A shares to the other categories of Chinese shares in the index will increase the China weighting in the emerging markets index from 19% to 28%. It will also impact the overall world and world ex US indices (to a lesser extent) and the Asia Pacific and Asia Pacific ex China (to greater extent ) compared to the emerging market overall index.

From an article that initially appeared in the Hong Kong Economic Journal May 18

MSCI index is a widely-used index for global money managers. More than 90 percent of global institutional asset managers use the index in North America and Asia. There are 5,719 funds tracking MSCI index, with total assets of US$3.7 trillion.

Given this situation, inclusion of A-shares will lead to substantial capital flow into Chinese stocks.

According to some analysts, the capital inflow effect will remain pronounced even if the A-shares inclusion takes place in 2016. By mid-2017, Chinese equities will account for 30 percent of MSCI Emerging Markets Index plus existing Chinese stocks in the US market. That would bring additional US$30 billion capital for Chinese equities, and US$17 billion capital inflow for A-shares.

The most conservative case would bring in over US$1 billion for A-shares. Capital flows could get a further boost as Dow Jones & Co. is also said to be mulling an inclusion of A-shares in some indexes.

In fact, many global institutional investors are seeking to adjust their portfolios, with some shifting from zero allocation to balanced allocation for Chinese stocks.

There is half chance for inclusion of A-shares this June, but the inclusion may actually take place next year. This is prompting global investors to take a fresh look at A-shares.

Of course there is no way to precisely gauge the future impact. But the change is significant and should affect markets for a considerable time in the future. For those that own international and particularly emerging markets ETFs it is definitely something important to monitor.

I have noted before that I don’t think emerging markets as an asset class make sense as a way to look at the financial markets and asset allocation. I have noted that in my view the prospects for emerging Asia look more positive than those for other countries in the index. This move will shift the country weightings in the overall emerging markets into the higher weighting in emerging Asia.

ASHR the Chinese A shares ETF is up over 9% since May 15 through May 22 and up another 4.5% as of mid morning May 26...could that be related to the news items cited above ?