October 2018
The MSCI China A-shares inclusion, which officially started on 1 June 2018, means the China A-shares market is more relevant for global investors than ever. But why should a global investor buy into China A-shares, given they already have exposure to China through existing allocation to emerging markets or Asia?
The opening of the China A-share market is poised to be one of the most transformative events in financial markets over the next decade.
Clients are now able to tap into the full China equity pool, with a larger market cap than the EU area.
Stock connect programs have lowered the cost of accessing China A-shares and the improved accessibility means they will increasingly be added to global equity indices. MSCI recently announced a consultation to increase the A-Share weighting by four times in their EM Index.
China A-shares provide meaningful portfolio diversification given their low historic correlation with other equity markets. They also allow better access to investment opportunities reflecting China's future economic growth drivers.
Portfolio construction: Adding China A-shares to a typical EM equity strategy can help enhance risk – return profile.
China equity is not a new concept for emerging market participants. Today, China equities account for around 30% of the MSCI Emerging Market Index (“MSCI EM Index”) and 35% of the MSCI AC Asia ex Japan Index (Source: Bloomberg, Allianz Global Investors, as at 30 June 2018). And these index levels are very likely to increase. On 1st June 2018, MSCI included China A-shares into its emerging market indices for the first time. This article assesses the likely long term impact on investor future allocations to China & concludes that as a first step adding China A-shares can help improve risk - return profiles. Over the longer term, we expect more investors are likely to decide to allocate to China in its own right.
China A-shares are Chinese stocks listed on the Shenzhen and Shanghai Stock Exchanges, and traded in Renminbi. They consist of more than 3500 listed equities equivalent to around USD 8.6 trillion market capitalisation (Source: Bloomberg, Allianz Global Investors, as at 30 June 2018). Of these, around 1500 China A-shares companies can be easily accessed through the widely-used stock connect schemes (Source: Shanghai Stock Exchange, Shenzhen Stock Exchange, as at 4 June 2018).
In addition to the size of the opportunity set, China A-shares offer a much more diverse universe for investors, especially in structural growth areas such as consumers, industrials, IT and new materials. For example, there are around 320 industrial and consumer stocks within the MSCI China A Onshore Index. This is compared to only around 50 in the offshore China exposure of MSCI EM Index. Most of these stocks are unique to China A-shares, including Chinese spirit brands with a market cap bigger than Diageo; pharmaceutical companies providing diabetes treatments for the aging population, and other names related to areas such as electric vehicle, environment monitoring and IT infrastructure.
This is for illustrative purposes only, not a recommendation or solicitation to buy or sell any particular security.
China A-shares can also help EM investors diversify away from mega caps. Approximately half of the MSCI China A-shares Onshore Index is represented by companies with a market cap below USD 10 bn. The equivalent number is only 10% in offshore China.
Why invest into the ‘new economy’, smaller cap companies? One intuitive answer is that these opportunities represent the future drivers for China’s economic growth - consumption, technology and innovation. More than half of China’s GDP is contributed by services. China is a major investor in and one of the world’s leading adopters of digital technologies, especially in the consumer space. And this rich digital ecosystem expands beyond just a few giants, such as Tencent and Alibaba - China is home to one third of the world’s unicorns, that is privately owned companies with more than USD 1 billion market cap (Source: McKinsey Global Institute, Digital China: Powering the Economy to Global Competitiveness, as at December 2017).
This is for illustrative purposes only, not a recommendation or solicitation to buy or sell any particular security. Past performance is not a reliable indicator of future results.
China A-shares have some further characteristics which make them very different from the typical China exposure you might get in an EM portfolio. More than 90% of the revenue of China A-share companies is domestic driven and therefore relatively less sensitive to global macro trends. In addition, China A-Share markets are dominated by domestic retail investors, who are typically short term and momentum driven. They therefore behave very differently from global institutions. These elements combined have resulted in a low correlation between China A-shares and the rest of the world. The historical correlation between China A and MSCI EM Index is less than 0.4, meaning 60% of the time these two asset classes move in different directions1.
As a result, from a portfolio construction perspective, adding China A-shares can potentially enhance the risk / return profile for an Emerging Market equity portfolio.The back test above shows that adding Allianz China A-shares into an EM portfolio would not only have improved returns but also reduced the overall level of volatility. The same analysis shows similar results using MSCI AC Asia ex Japan and MSCI ACWI Indices2.
1Source: Bloomberg, Allianz Global Investors, as at 30 June 2018. Correlation data is calculated based on historical weekly USD return of MSCI EM Index and MSCI China A-shares Onshore Index.
2Source: Bloomberg, Allianz Global Investors, as at 30 June 2018. Hybrid portfolio is calculated using monthly return since March 2009, based on gross returns of MSCI ACWI Index, MSCI AC Asia ex Japan Index and Allianz China A-shares on a USD basis, assuming monthly rebalancing.
Over the coming years, it is very likely that the China A-shares weighting in the MSCI EM Index will increase significantly to reflect the size of A-Share markets. And an emerging market portfolio of the future will therefore likely look significantly different from today.
Assuming a 100% inclusion factor of large and mid cap stocks listed on the Shanghai and Shenzhen stock exchanges, China A-shares would rise to 28% of the MSCI EM Index. This combined with offshore China means 50% of the MSCI EM Index would be represented by Chinese equities. Many active investors have already started positioning for this structural change. In May 2018, purchases of China A-shares through the stock connect schemes reached a historical high of RMB 51 bn (~USD 8 bn) (Source: Haitong International, as at 31 May 2018). Since the launch of the Shanghai stock connect in late 2014, there has been cumulative buying of RMB 485 bn (USD 76 bn) into China A-shares. Despite this step change, foreign investors still only own around 2% of the total China A-Share markets3.
3Source: Goldman Sachs, ’A’ primer for global investors (second edition), as at 16 May 2018 Grassroots® Research is a division of AllianzGI that commissions investigative market research for asset-management professionals. Research data used to generate Grassroots® Research reports are received from independent, third-party contractors who supply research that, subject to applicable laws and regulations, may be paid for by commissions generated by trades executed on behalf of clients.
From our own experience a growing number of foreign investors are choosing to access China A-shares as a strategy separate to their emerging market allocations.Our view is that over time, the natural next step is for investors to allocate to China - both onshore and offshore combined - as a separate asset class when it becomes too dominant in EM indices. This would be consistent with the way global investors allocate to other dominant economic regions such as the US, Europe and Japan.