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Chinese A-Shares: What Will MSCI Decide, And Who Wins?

A decision centering around Chinese stocks could fundamentally change some core portfolio holdings

Chinese A-shares — stock for companies based in mainland China — have been on an absolute tear this year, up by nearly 50% as measured by the Deutsche X-trackers Harvest CSI 300 China A-Shares ETF (ASHR).

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And MSCI Inc (MSCI) might be about to dump gasoline on the fire.

The stock market index provider is mulling adding Chinese A-shares to its Emerging Markets Index — as in, the index that backs $1.7 trillion in emerging market mutual funds and ETFs, including the iShares MSCI Emerging Markets ETF (EEM). And the decision is expected out soon — 5:30 p.m. ET (Wednesday morning in Shanghai), to be specific.

The consensus view is that the inclusion of A-shares is all but certain … eventually. It’s anyone’s guess whether it happens today, next month or five years from now.

As the world’s second-largest economy, the exclusion of Chinese A-shares is something of an oddity. Investors have had access to Chinese stocks for years via Hong-Kong-traded H-shares, but up until very recently, it was all but impossible for non-Chinese buyers to get access to the domestically traded A-shares. The aforementioned ASHR is one of those rare outlets.

This is the major sticking point for MSCI. To include a country’s stock market in the MSCI Emerging Markets Index, it needs to be sufficiently liquid and open. Otherwise, large inflows and outflows of capital can massively distort prices.

So, the question for MSCI is whether China’s recent reforms — including its Stock Connect program, which links the Hong Kong and Shanghai markets — have gone far enough.

My best guess is that MSCI stops short of fully including Chinese A-shares today, but that they set some sort of timetable for inclusion within the next 12 months.

What investors obviously want to know is: Under this scenario, who wins and who loses?

Who Wins?

The most obvious winners are China’s local investors and foreign investors currently invested in A-shares. The A-shares could very easily account for as much as 23% of the MSCI Emerging Markets Index, which means that every mutual fund and ETF that benchmarks itself to the index will be heavily buying Chinese stocks, irrespective of price. That could mean hundreds of billions of dollars flowing into A-shares over a very short period of time.

There’s expectations that A-shares will see something similar with the inclusion in FTSE indices and the funds that track them — such as Vanguard FTSE Emerging Markets ETF (VWO) — though MSCI would have a much greater impact.

But more broadly, investors in emerging markets will benefit. As I wrote recently, the iShares MSCI Emerging Markets ETF in its current form does not live up to its name. Far too much of the EEM ETF is invested in developed markets like South Korea and Taiwan. Properly including Chinese A-shares and bumping South Korea and Taiwan into developed market status would go a long way to fixing this.

A surprise winner, though, could be investors in Chinese H-shares.

You might think a global rebalancing from H-shares into A-shares would depress H-share prices, and under more normal conditions, you’d probably be right. But today, we actually have something of an arbitrage opportunity: Many of China’s largest companies trade as both A-shares and H-shares, yet the A-shares trade at a large premium.

As foreign money floods into all classes of Chinese stocks, I would expect savvy arbitrageurs to close that gap.

Who Loses?

Carving out space for Chinese A-shares means that virtually every other country in the MSCI index will now have a slightly smaller slice of the pie. For example, a recent report estimated that $3.8 billion would be yanked out of India’s stock market as investors reallocate.

Also — and ironically — investors in A-shares could end up losing if this turns into a case of “buy the rumor, sell the news.” We don’t know how much of the recent run-up in Chinese A-shares prices is due to anticipation of MSCI’s move. But it has been discussed at length for years, and the optimism has been high for months.

On balance, I’m bullish on Chinese stocks — both A-shares and H-shares.

While China’s economy is slowing, Chinese stocks are not particularly expensive. According to Wellershoff & Partners, China’s market trades at a cyclically adjusted price/earnings ratio of 19, which is below its long-term average of 24 and suggests very decent returns going forward.

It seems that most investors have doubted this rally in Chinese stocks from the beginning, which is generally a positive sign.

Charles Lewis Sizemore, CFA, is chief investment officer of the investment firm Sizemore Capital Management and the author of the Sizemore Insights blog. As of this writing, he did not hold a position in any of the aforementioned securities.

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