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Special Report: Indices are Evolving on Asia; Are You?

By Chris Hall May 24, 2019

Index inclusion for Chinese A-shares opens opportunities for U.S. investors, and perhaps a can of worms for their advisors. This is Part Five of a five-part series on Investing in Asia.

The portfolios of most private wealth clients reflect neither today’s global macroeconomic realities nor tomorrow’s earnings expectations, with consensus forecasts placing Chinese and Indian firms on a faster growth trajectory than their U.S. counterparts – at P/E discount.

But plans are already in progress that will do at least some of the heavy lifting for financial advisors. Across equities and bonds, index providers are starting the careful process of including a wider range of Chinese securities in the benchmarks used by both passive and active managers to guide decisions on trillions of dollars of assets under management.

“Today more than ever, it’s important that investors get Asia right.”
David Dali
Matthews Asia
MSCI, FTSE Russell and S&P Dow Jones are all increasing the representation of A-shares in their global and emerging market indices, obliging passive vehicles such as ETFs to hike their holdings of Shanghai- and Shenzhen-listed stocks. Active managers are not compelled to follow suit, but for benchmarking purposes they are expected to increase their holdings over time. In January, the China Securities Regulatory Commission estimated higher A-share weightings in global benchmarks could double foreign capital inflows to $88 billion this year alone.

In May 2018, MSCI added more than 200 large-cap A-shares to its EM index, which over the last decade has doubled its China weighting to 31.1%. Further adjustments (see table) not only automatically increase the China exposure of passive investors but begin to offer access to previously underrepresented sectors of its economy, such as mid-cap consumer discretionary firms.

There are parallel changes in debt securities. Starting in April 2019, Chinese government bonds are being gradually included in the Bloomberg Barclays Global Aggregate Bond Index, lifting China’s weighting to around 5.5%. Indices operated by JP Morgan and Citi are enacting similar changes.

These changes signal Chinese securities are safe for international consumption. For China, they represent a key milestone in its integration into the global financial system. By building the necessary access channels, China is actively encouraging the international capital flows into its private sector that will enforce market discipline and stimulate further growth – provided firms respond with greater innovation, competitiveness and transparency.

“Chinese policy is for firms to rise up the value chain,” says Mark Mobius, founding partner, Mobius Capital Partners.

But what does this mean for the canny investor? Index providers insist that risks are being mitigated in the pursuit of new opportunities.

“The increase in the number of A-shares included in EM global indices presents a market opportunity for firms to step in and offer access to a range of wide sectors. As investors become more familiar, a lot of different types of exposure can be offered,” says Penny Ning Pan, director of product management at FTSE Russell. “With 300+ small-cap firms qualifying for inclusion in our indices from June, investors should bear in mind that these companies pass our standard screening on liquidity and free float; we also take into account foreign ownership limit and foreign headroom when determining index weights.”

Arguably, the increased A-share weightings offer an opportunity to turn attention away from China to unearth opportunities across the wider Asian region, knowing RMB-denominated exposures are in hand.

Ameriprise global market strategist Anthony Saglimbene suggests financial advisors should look to countries following China up the value chain, noting U.S.-China tensions will accelerate a redirection of supply chains to countries with lower costs bases. “Many Americans will already have exposure to these countries through their international and U.S. investments,” he says, citing South Korea and Singapore among those well-positioned to benefit.

Tai Hui, chief market strategist for Asia at J.P. Morgan Asset Management, cites southeast Asia in general, and Vietnam and Indonesia in particular, as markets with the infrastructure and appetite to take advantage. “Most firms are still thinking about this issue, which means there are opportunities to invest in those with the most advanced diversification plans,” he says.

As a strong advocate of the need to increase private wealth clients’ overall exposure to Asia, Matthews Asia portfolio strategist David Dali says there are risks in over-reliance on benchmarks to tap the region’s growth. In a recent blog, Dali flagged the structural biases of indices (toward large stocks, large countries and sectors including technology) and the challenges for managers of separating the wheat from the chaff in an investable EM universe of 14,000, three-quarters of which are largely unknown small-caps. Be prepared for a lot of ‘frog-kissing.’

“Financial advisors must educate themselves about the weighting biases of EM benchmarks as part of understanding how much the Asian environment has changed,” he says. “Today more than ever, it’s important that investors get Asia right.”