During our consultations on whether to add China A-shares to MSCI’s Emerging Markets Index, some institutional investors asked what full inclusion might mean for the index and the asset class. Given China’s already significant weight in the index, would the addition of shares of local Chinese companies, even if years away, reduce diversification of the index and render the asset class irrelevant?
The short answer is no. As discussed in the questions and answers that follow, data suggest that full inclusion of A-shares would have improved diversification of the index historically.
What effect would inclusion of A-shares have on diversification of the MSCI Emerging Markets Index?
To help investors understand the impact of inclusion, MSCI recently launched a series of illustrative indexes with partial A-shares.¹ A 5% partial inclusion, as proposed in the latest review, would have increased the presence of China in the index to about 28%, from 26%, as of September 30 (with 5% inclusion of A-shares equivalent to 1% in the index). Longer term, full inclusion would raise China’s proportion of the emerging markets index to about 40% of the index, assuming China were to take steps outlined to bring access to financial markets in line with international norms.
Potential inclusion road map of China A-shares
Source: MSCI Research, as of Sept. 30, 2016
A-shares have moved in a different direction than emerging markets about 35% of the time, suggesting that A-shares could have improved diversification of the index historically. Broadening the investment universe also creates opportunities to diversify portfolios. Inclusion of A-shares would add 434 new companies to the index and balance the sector weights.
Would full inclusion of A-shares cause investors to spin out China as a separate mandate?
At the heart of the matter is deciding who is best equipped to make the China allocation decisions, whether strategic or tactical. We will explore these issues in more detail in a forthcoming paper.
For the time being, we note that the performance of active managers has tended to correlate positively with the breadth of the benchmark universe, highlighting the value of having a broad exposure. Conversely, subdividing the universe introduces mis-timing risk (and a related agency question) and could lead to suboptimal portfolio construction.
Currently, few emerging markets strategies offer comprehensive coverage of A-shares. So by default, many investors have turned to specialist A-shares managers to obtain exposure to that market segment. If A-shares were to join the MSCI Emerging Markets Index and become part of mainstream emerging market portfolios, the current off-benchmark allocation could be absorbed by an integrated emerging markets allocation.
Didn’t similar concerns lead MSCI to separate Japan from Asia benchmarks in the 1980s?
The experience of Japan differed. Because of inflated prices, Japanese equities accounted for nearly 60% of international equity portfolios. Anyone wanting to add a dedicated Asia allocation would have essentially duplicated the large Japan weight; thus most removed it. In addition, Japan was a mature economy, while the investment case for emerging Asian countries was mostly about growth and diversification. Since the 1980s, institutional equity allocations have changed substantially and become more globalized. Even with full inclusion of A-shares, China would account for just 5% of the MSCI ACWI Index. It is not clear that investors would see the merit of an over-engineered asset allocation framework.
How might institutional investors choose to implement an allocation to A-shares?
While active investors welcome precision in implementation, passive investors may favor an integrated emerging markets allocation to capture the beta efficiently and precisely. An integrated and consistent benchmarking framework — without artificial divisions — provides a neutral starting point for expressing investment views.
¹The indexes address the desire of some clients for a limited allocation to A-shares. As we noted on Sept. 29, there have been positive market developments since June, when MSCI announced that we would delay including China A-shares in the MSCI Emerging Markets Index but would retain the A-shares inclusion proposal as part of our 2017 market classification review.
The views expressed above are the author’s and do not prejudge the outcome of the road map for inclusion of China A-shares that MSCI announced in June.
2016 Market Classification Announcement
Consultation on China A-Shares Index Inclusion Roadmap
Built to Last: Two Decades of Wisdom on Emerging Markets Allocations