In another important milestone for China and a key development for global investors, MSCI will quadruple the weighting of China A shares in its Emerging Markets (EM) Index this year. It has already completed the first of three increases in May 2019, taking the inclusion factor of China A Large Cap equities from 5% to 10%, with further rises to 15% and 20% planned for later in the year.
These changes mean that investors will have to reassess their China equity allocations. By the end of 2019, China A shares will have a weighting of approximately 4% in the pro forma MSCI Emerging Markets Index, up from 1% at the beginning of 2019, and become too large to ignore (Figure 1).
MSCI is also adding Mid Cap shares to its indexes in November 2019. By that time, the MSCI EM Index, based on proforma, will include 253 Large Cap China A shares and 168 Mid Cap shares, including 27 ChiNext stocks, with a 20% inclusion factor. MSCI estimates that full inclusion will result in China A shares representing 43% of the MSCI EM Index, with half of the stocks on the Index being onshore or offshore Chinese listings.
Zhen Wei, Executive Director and Head of China Research, MSCI, explained that the benchmark index change has important implications because most investors are currently under-weighted in China equities – even against the current Emerging Markets benchmark index.
“China shares already account for 30% of the MSCI EM Index, but many mutual funds’ allocation to China were below 25% at the end of 2018”, he revealed at the BNY Mellon Asset Servicing webcast on 29 May.
According to Mr. Zhen, China is under-represented in the global and emerging equity market opportunity set. For example, China accounts for around 4% of global equity market capitalization weight, whereas the US is 55%. Breaking down the same opportunity set via the MSCI ACWI Index, around 16% of global cash flow or revenue is generated by Chinese companies and only 29% by US companies. Furthermore, China is expected to contribute more than 20% of global GDP within five years, rivalling the historical dominance of the U.S.
This disparity shows us that investors are still underprepared to bridge the gap between China’s market representation and the fundamental reality of its contribution from a cash flow and GDP perspective.
“A minority of investors want to delay incorporating China A shares into their allocations because they are ill-prepared and unfamiliar with the market. Others are responding passively by following the index evolution. However, the majority are seeking to correct their positioning by bringing their China weight on par with the equity benchmark” said Mr. Zhen.
Benchmark-sensitive investors are embracing the integrated benchmark universe by regarding China as part of the broader opportunity set. Some have adopted the EM Index with full China inclusion, while others are applying a revenue weight or GDP weight to reflect the market’s economic significance.
“Investors that are less benchmark sensitive may want to treat China as a separate equity segment like the US”, Mr. Zhen explained. When the choice is between an integrated EM strategy with China or a dedicated China strategy, some investors choose a dedicated strategy because their EM managers may be less ready in managing China A shares. However, reconfiguring the EM sleeve into two allocations – one China and one EM excluding China – remains problematic and restrictive, as most managers may find it difficult to manage an EM universe without any Chinese equities.
In general, foreign investors appreciate China’s efforts to make its capital market more accessible, but some accessibility issues remain (Figure 2).
Chief among them is the short settlement cycle for China A shares, which requires trades to be cleared and settled according to onshore market rules, where security settlement takes place on Trade Date (TD) and money settlement on TD+1. With other MSCI EM Index constituent markets operating on a TD+2 or TD+3 settlement cycle, this disconnect causes operational friction and creates problems from an index tracking perspective.
“The short settlement cycle creates operational challenge as the post trade settlement processing timeframe is short and may lead to risk of settlement failure. This is a particular concern for foreign investors without presence in Asia, as they cannot easily meet the market cut-off time,” said Magdalene Tay, Custody Product Manager, Asia Pacific, Asset Servicing, BNY Mellon.
To support such foreign investors without presence in Asia, BNY Mellon has two Stock Connect service models (Figure 3). The first allows single-sided settlement for delivery versus payment (DvP), with auto-created instructions based on broker details received from the central depository. In the case of purchase transactions, settlement is based upon instruction from the client who generally made prior arrangement with their broker to settle on TD+1 basis. This gives client sufficient time to instruct and fund their transactions.
The other service model is SPSA Plus Pershing, which builds on the Hong Kong Stock Exchange’s Special Segregated Accounts model, with Pershing LLC acting as an agency broker for foreign investors. It provides a seamless, end-to-end process from trade execution to custody, with settlement finality on Trade-Date without requiring client instruction.
“Importantly, SPSA Plus Pershing allows foreign investors to tap into China A-shares via Stock Connect during their time zone,” Ms. Tay noted.
China’s ongoing efforts to enhance market accessibility for foreign investors are key to its agenda on financial markets reforms.
“Among key upgrades investors have asked for, many would like to be given access to a listed futures market and other derivatives products to enhance risk management as they scale their portfolios with higher inclusion ratios”, said Mr. Zhen.
The misalignment between offshore and onshore trading holidays also needs to be addressed, and the introduction of an omnibus trading account, that is an account which allows local brokerages to combine individual investors’ trading accounts, would be welcomed by large fund managers and broker dealers for greater efficiency and lower cost.
Further reforms would pave the way for more positive investor feedback and an accelerated path towards full inclusion of onshore securities in global indices. This is particularly important at the current juncture, when China faces domestic pressures from its economic rebalancing and escalating trade tensions with the US.
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APAC Custody Product Manager, BNY Mellon Asset Servicing
Magdalene Tay is the APAC Custody Product Manager for Asset Servicing based in Singapore. In her current role, Magdalene is responsible for core custody related product development and key market initiatives in the region. Magdalene is a specialist on the China market and is currently developing a China access roadmap for BNY Mellon clients.View Profile