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How China is Dominating Emerging Market Funds

A decade ago, the emerging market index was dominated by Taiwan and South Korea, and China accounted for a meagre 4%. Now China makes up 26%

Germaine Share 19 October, 2016 | 11:28AM

At its May 2016 index review, MSCI completed the addition of a number of US-listed Chinese companies into its MSCI Global Investable Market Indexes. As a result, China’s weighting has increased in a number of key indexes, and its role in global portfolios has also been amplified. In addition, we believe the indexes now better represent the underlying growth drivers of the Chinese economy, which has various implications for portfolio managers and investors.

Inclusion of A-shares could raise China’s weighting in the index to almost 40%

China’s progressive financial market liberalisation has spurred numerous IPOs and the success of a number of Chinese companies, which has been reflected in their gigantic market capitalizations, such as Tencent.

This has had a significant impact on the evolution of China’s weighting in the MSCI Emerging Markets Index. A decade ago, the index was dominated by Taiwan and South Korea, and China accounted for a meagre 3.69%. Fast forward to 30 June 2016, and, fuelled by the recent addition of a number of US-listed Chinese companies into the index, China has become the largest country weighting at 25.79%.

China Set to Grab Even More of the Market

The story does not end there. China will continue to gain global importance as it improves accessibility to its onshore A-share market, one that offers better liquidity and a more diversified opportunity set than the Hong Kong stock market, which is currently the most commonly used avenue to get Chinese exposure. Many asset managers believe it is only a matter of time before A-shares are included and have accordingly been beefing up their A-share research capabilities or even managing their portfolios against a custom benchmark that includes A-shares.

How the make up of the MSCI emerging markets index has changed

Referencing to MSCI’s “Consultation on China A-Shares Index Inclusion Roadmap,” a potential full inclusion of A-shares can raise China’s weighting in the MSCI Emerging Markets Index to almost 40%. That said, this will require among other things, China’s full liberalisation of its capital mobility restrictions, and it will likely take a long time to materialise. The inclusion of US-listed Chinese companies – often referred to as American Depositary Receipts, or ADRs – into the MSCI indexes has undoubtedly helped to better reflect the Chinese investment universe and provide more-relevant performance benchmarks for portfolio managers and investors alike.

How the Chinese Stock Market is Diversifying

Prior to the ADR inclusions, the Chinese exposure of various indexes predominantly came from the “old economy,” that is, the traditional state-ownership-heavy sectors such as banks, energy, and telecom services. To put this into context, we examine the MSCI China Index, a popular benchmark among Chinese equity managers, and one which had shown the most pronounced changes.

Taking its 30 November 2015 portfolio and assuming that there were no ADR inclusions, the yellow bar in the graph below shows how the index’s sector allocations would look as at 30 June 2016, adjusted for stock price movements. The financial sector, which comprises banks, insurers, and property developers, until 30 August 2016, when MSCI adopted a new real estate sector in its global industry classification standard structure, was by far the most prominent sector and accounted for 40% of the hypothetical index.

Other mature industries, such as the telecom services and the energy sectors, accounted for 11% and 9% of the index, respectively. MSCI added 14 ADRs to its indexes as a result of the index review. Many of these new constituents are privately owned “new economy” companies, particularly Internet-related companies. As a result, the MSCI China Index’s information technology exposure dramatically increased from 17% to 31% in Exhibit 2, where the orange bar depicts the MSCI China Index’s actual sector allocations as at 30 June 2016.

The stock sectors that make up the Chinese stock market

Notably, Alibaba and Baidu became index giants and accounted for 8.15% and 4.64% of the index, respectively. The index’s consumer discretionary exposure also doubled from 4% to 8%. On the flip side, the once-overriding financial sector now shares its top position with the IT sector at around 30%.

We think that these changes better align the index with the growth drivers of the Chinese economy, with an increased representation of the in-demand service industries, such as the IT and consumer sectors. These sectors are arguably more directly exposed to the Chinese domestic-consumption story, a popular long-term investment theme as China looks to transition away from an investment-led economy, than some of the traditional sectors such as oil and gas.

From a quality perspective, the substantial increase in the more privately owned new-economy sector has indirectly diluted the exposure of state-owned-enterprise-heavy old-economy sectors such as banks, energy, and materials. This shift in ownership dynamics presents a differentiated opportunity set for portfolio managers, one that focuses on return-on-equity potential and the alignment of interests between management and shareholders.

How Active Fund Managers May Benefit

Investors in benchmark-aware strategies, that is, funds with relatively tight tracking-error budgets and not much leeway to deviate from the index, can expect increased exposure to the added index constituents, whether their portfolio managers believe those names have strong investment merits or not. For example, a few benchmark-conscious portfolio managers invested in Baidu despite their belief that the company has over-monetized its search results. Nonetheless, they bought the name to manage benchmark-relative risks and expressed their disflike through an underweight position.

On the other hand, some have had the foresight to invest in select U.S-listed Chinese companies prior to the inclusion exercise and captured considerable upside before the huge buy-in from the market. The Chinese investment universe has continued to expand and evolve, and China is becoming an increasingly important part of global investors’ portfolios.

Improving accessibility, such as the recent implementation of the Shenzhen-Hong Kong Stock Connect, provides another channel for offshore investors to invest in the domestic Chinese equity market. As one of the world’s largest economies with diversifying growth drivers, we believe China presents exciting investment opportunities to global investors.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

About Author

Germaine Share  is a Senior Analyst for Morningstar