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Financial Times / Biz - Money

China A-shares offer conflicting bets over time

The moment to buy Chinese A-shares is almost at hand. The world’s investors have deputed this decision to MSCI, the indexing company that compiles the most widely used emerging markets benchmark, and next month A-shares will begin to take their place.

We now have the final details on how the process of including A-shares in the MSCI Emerging Markets index will unfold. It starts with the inclusion of 234 large-cap A-shares, carefully vetted for their liquidity, next month. Stocks that have had an undue number of trading suspensions, a key reason behind MSCI’s delays in including A-shares, will have to wait further.

China’s stocks will be included at a far lighter weight than their market value. To start with, they count for only 5 per cent of market cap, and will be only 0.78 per cent of the index. But while this is not as yet a huge macroeconomic deal, it is the start of a hugely important process — and it is now that institutional investors must decide on their strategies for building exposures to China.

It is deeply disquieting that an issue like this should be left to a relatively small for-profit company in Manhattan. Deciding the ground rules for how institutions invest in domestic Chinese stocks should naturally be an issue for democratically accountable regulators or transnational organisations. But as is stands, MSCI’s role remains crucial.

Some complain that they are moving too slowly, but without good reason. If fund managers want to invest a large chunk of their funds straight away in A-shares, MSCI has no power to stop them. It is only managers’ aversion to the risks that come with deviating from their benchmark, or just doing something differently from their competitors, that is holding them back.

MSCI has moved with commendable caution, and has certainly taken the process far more slowly than Chinese regulators wanted. It is now up to big investors to decide how to respond. Two questions are paramount. First, are there opportunities to find value among the A-shares that have been included in the benchmark? And second, are they a “buy” for the long-term?

On the issue of value, it does look as though the MSCI announcement has not prompted the front-running that often accompanies index changes. Since last September, when MSCI started its “inclusion” index of the A-shares that would be included in the benchmark, the favoured A-shares have underperformed MSCI’s existing China index, which is based on Hong Kong-quoted H-shares. The A-shares have gained 4.8 per cent in that time while the H-shares are up 13.6 per cent.

The A-shares to be included in the MSCI index are overweight in consumer staples, by far the most successful sector in recent years, which could make the benchmark easier to beat.

There is also every reason to assume that the market is inefficient, at least by comparison with developed markets. The limits on ownership and trading are complicated and inconsistently applied, so the existence of some anomalies is inevitable.

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Even if China’s authorities clean up the rules more quickly than is expected — and MSCI leaves open the chance that it could admit A-shares more quickly if they do — there is the issue that Chinese markets are for now dominated by retail investors, not by institutions. The transition to an institutional market will change them. And, of course, there is the issue of China’s dreadful corporate governance, which introduces levels of risk.

Collectively, these A-shares do not offer good value. According to a Liontrust analysis of stocks that are both A-shares and H-shares, the A-shares trade at a premium of almost 30 per cent to H-shares and have done so persistently for the last three years.

In the long run, however, A-shares are an obvious buy. Société Générale’s Alain Bokobza says: “With the growing discrepancy between China equities’ minimal weight in indices and their huge size measured by market capitalisation, as well as their fast-growing tradability, China equities might just replace small-caps in global equity portfolios as a source of structural outperformance.” In other words, they start from a lower base and seem an obvious candidate to do better than a benchmark in the longer term.

He adds that A-shares offer a mix of “leverage to the country’s domestic economy (something we want to buy for the next decade)” and “de-correlation as they should be largely insensitive to the next US crisis when it occurs”.

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