The company spearheading the inclusion of domestic Chinese shares into a global equity benchmark says investors face big challenges ranging from market volatility to poor corporate governance.
MSCI, the world’s leading equity index provider, will add 234 Chinese mainland-listed stocks to its flagship emerging markets index on June 1, obliging international fund managers who follow the benchmark to add domestic Chinese stocks to their portfolios.
The move represents a landmark moment in the integration of the world’s second-largest equity market into the global financial system.
But investors face challenges ranging from market volatility to poor environmental, social and corporate governance (ESG), a measure that helps asset managers mitigate risk.
On average, the 234 Chinese companies rank poorly on ESG criteria when compared with other stocks in the MSCI Emerging Markets index, MSCI said.
Thirty-seven per cent of the 234 domestic Chinese companies scored the lowest ESG rating of CCC, compared with 8 per cent of companies already in the MSCI EM index, according to MSCI research.
At the other end of the scale, only 3 per cent of the Chinese companies were placed in the top three out of seven ESG categories, compared with 22 per cent of the stocks that already comprise the MSCI EM index.
“There is a skew in the distribution, so we have more laggards compared to leaders,” said Sebastien Lieblich, managing director, research at MSCI. “Although the Chinese government is pushing a lot of green policies, nevertheless at a company level the ESG consideration has not yet been really embraced.”
With this in mind, MSCI is planning to launch China ESG indices sometime this year so that investors can help filter out the more risky companies. MSCI sells ESG ratings and research to its largely institutional investors clients.
Low ESG ratings are by no means the only complexity facing investors in A-shares. Another is the volatility in a market still dominated by the seesawing sentiment of Chinese retail investors.
Henry Fernandez, chairman and chief executive at MSC, said: “You have to look at companies, understand that there will be a significant amount of volatility caused by the structure of the market but understand what are the long-term prospects of those companies and stick with them for longer periods.”
Stockpickers often see the A-share market as a real opportunity as long as rigour is applied in finding the right companies. “Proprietary in-depth research, frequent company visits, patience and discipline are all essential ingredients to succeed when investing in that market,” said Francois Perrin, manager at Hong Kong-based East Capital.
MSCI used quantitative criteria including companies’ market capitalisation, proportion of freely traded shares and recent record on trading suspensions for choosing which stocks to include in its EM index.
A second tranche of stocks is set to be added to the index late this year, after which 0.8 per cent of the MSCI EM index will comprise A-shares.
The index provider sees this as a first step, with “full inclusion” being achieved when A-shares account for 16 per cent of the MSCI EM benchmark.
Already, some 30 per cent of the MSCI EM index consists of Chinese companies but these are listed offshore in Hong Kong and elsewhere and therefore abide by different market rules from A-shares. Nevertheless, after the “full inclusion” of A-shares, Mr Lieblich said, the total cohort of Chinese companies in the EM benchmark index will be close to 45 per cent.