In June last year, worldwide benchmark provider MSCI reclassified mainland Chinese stocks in a number of its flagship indices. This was a milestone moment in the integration of the world’s second largest equity market into the global financial system.
At the time, we looked at the potential impact of MSCI’s decision for investors, as well as the potential challenges and opportunities. Almost a year later, investors are preparing to include mainland Chinese stocks in a broad range of investment strategies. And as we approach the next milestone, we look again at what’s happening and the impact.
What’s going to happen now
MSCI is including the new stocks in two steps. The first step coincides with the May 2018 review, and will become effective on 1st June 2018. This is followed by a second step that’s part of the August 2018 Quarterly Index Review, effective on 3rd September 2018. MSCI plans to add 234 large cap China A stocks to relevant regional and global indices, including the widely tracked MSCI Emerging Markets index.
MSCI uses quantitative measures such as the companies’ market capitalisation (size), ratio of freely traded shares (liquidity), and record of trading suspensions (a particular issue in China) in selecting the stocks. The MSCI Emerging Markets index provides large and mid-cap exposure across 24 emerging market countries.
Following the first step in June, the addition of A shares will represent just 0.39% of the emerging markets index, rising to 0.78% with the second step in August. Although this is a small fraction in terms of both exposure and allocation to mainland China, it marks a paradigm shift in global investors’ perceptions. Up until now, the market has been greatly walled off – to all but a small group of institutional investors. But that’s about to change.
What this means for the investment landscape
China has long formed the largest part of emerging market equity investments and bringing mainland shares into the mix only improves this position. Investors across the globe are currently preparing for this change, but naturally the strategies that will feel this change most will be those with a dedicated focus on China.
Taking this to the next level, any investor in emerging markets will be observing this closely. Over US$1.6 trillion in assets under management1 is benchmarked to the MSCI Emerging Markets index alone. This change means that many investors, particularly those using passive routes such as index trackers and ETFs, will be required to hold yuan-denominated China A shares for the first time.
As we saw, the proportion of China A stocks will be very small to start with, but it’s expected that over the coming years MSCI may increase the weight, thereby paving the way for increasing investor exposure. The mainland China market is vast, with over 3,000 listed companies. This means full inclusion would lead to passive investors holding mid and small cap stocks as well.
For active managers, a decision will need to be made on whether they now take exposure to mainland China. They’ll also be required to develop investment views and analyse companies that may previously not have been a part of their investment universe.
What this means for Nutmeg portfolios
At Nutmeg, we view China as an attractive investment opportunity over the medium to long-term. Gaining access to large and medium-sized companies within a fast-growing economy that also represents roughly 20% of the global population is an attractive option. China continues to modernise at speed, with consumer, service and technology sectors developing rapidly. China is second to the US in terms of disrupting old-economy business models2.
That said, despite promising prospects, we’re cautious about taking direct positions in Chinese stocks and prefer to gain diversified exposure through global emerging market (EM) strategies. With accelerating production growth across developing economies, alongside recovering global trade, and attractive valuations, we think emerging markets are still well positioned to outperform over the coming years.
We hold a number of emerging market equity strategies in our portfolios, such as the iShares MSCI Emerging Markets IMI UCITS ETF (EMIM), and the iShares Edge MSCI EM Minimum Volatility UCITS ETF (EMV). From 1st June, both of these strategies will begin to hold a small allocation of Chinese A shares. We estimate that this will be no more than 0.40% for EMIM, and 1.30% for EMV. This means our investors will be gaining a small exposure percentage-wise. However, it’s important to note that there is exposure to additional Mainland Chinese companies in the holdings, which will amount to 234 stocks for EMIM and 14 stocks for EMV.
We routinely review our exposures. So, if any of the trends we monitor pick up pace, or other market elements result in our views changing, we will adjust our fully managed client portfolios accordingly. As always, we continue to manage our portfolios to ensure that there is a good balance between levels of risk and potential returns.
Risk warning
As with all investing, your capital is at risk. The value of your portfolio with Nutmeg can go down as well as up and you may get back less than you invest.
Sources
- As of June 30, 2017, reported on September 30, 2017 – MSCI
- IMF data – World Economic Outlook
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Rumi Mahmood
Rumi Mahmood is an investment analyst here at Nutmeg. He has two years’ industry experience and joined in early 2017 from the Bank of New York Mellon, where he was an analyst in Global Securities Operations. Rumi holds a masters degree in Engineering from the University of Manchester.Other posts by Rumi Mahmood