SINGAPORE (July 3): After three years of consultations, index operator MSCI announced on June 20 that it would be adding 222 A-shares to the MSCI Emerging Markets Index and several other indices. Prominent names on MSCI’s list include financial behemoths such as Bank of China, China Merchants Bank Co and Ping An Insurance Group Co of China, as well as Tsingtao Brewery Co and Hai nan Airlines Holding Co.

Bank of America Merrill Lynch analyst David Cui expects the MSCI decision to bring some US$3 billion ($4.1 billion) of passive inflows and US$18 billion of active inflows into the A-share market, as funds alter their portfolios to factor in changes in benchmark weightings. Should investors be buying into these stocks? What are the best ways to play this China story?

For years, investors who wanted to bet on the fast-growing Chinese econo my were limited to H-shares listed on the Hong Kong Stock Exchange or through American Depositary Receipts (ADRs). Access to the A-share market, that is, renminbi-denominated stocks listed in Shanghai or Shenzhen, was limited to qualified foreign institutional investors. The QFII programme allows institutional investors who meet certain requirements to invest in a limited scope of cross-border securities products.

Since the launch of the Shanghai- Hong Kong Stock Connect in November 2014, however, access to the A-share market has improved. Most flows into China’s US$7.4 trillion A-share market today take place through the cross-boundary investment channel linking the Hong Kong exchange with the Shanghai and Shenzhen bourses.

The addition of A-shares to MSCI indices is likely to generate even more interest in the Chinese equity market. This “could be a big boost to the world’s second-largest stock market, which has until now drawn limited foreign investor interest because of high volatility and frequent trading halts”, says KGI Research.

Historical data shows inclusion in the MSCI does have a positive impact on stock market performance in the short term, says Jennifer Li, chief analyst at CSOP Asset Management. “Taiwan and South Korea, which were included in the MSCI family in the 1990s, both witnessed more than 20% increases in their major benchmarks within six months after the initial inclusion.”

Li notes that the large-cap CSI300 and FTSE China A50 indices have added more than 1.5% in the week since the MSCI announcement, outperforming their small- and mid-cap counterparts. “We think MSCI’s announcement on June 21 rekindled investors’ interest in blue chips, and the gains in the large-cap indices are partly because MSCI’s initial inclusion plan only covers 222 large-cap A-shares,” she says.

Upside may be limited However, investors should not get overly excited. The inclusion of the 222 stocks in MSCI’s indices will take place in two phases, in May and August next year. At a 5% partial inclusion factor, the inclusion represents just 0.73% of the MSCI Emerging Markets Index.

Moreover, full inclusion could take several years. It took a full six years, from 1992 to 1998, in the case of South Korea, and five years, from 1996 to 2001, for Taiwan to be fully included. “We expect China could follow a similar path, taking five to 10 years to full inclusion, with a gradual increase in inclusion weights along the way as capital flow restrictions are reduced and the A-share market converges closer to international rules,” says Sean Quek, head of equity research at Bank of Singapore. “Any benefits accrued are going to be spread out over a long time period.”

Some analysts say the inclusion is more symbolic than material in the short term. “The significance of inclusion does not lie in the immediate capital inflows. Instead it marks a larger symbolic milestone that highlights the size and significance of China’s domestic stock market,” says Jack Lee, head of China A-share research at Schroders.

East Capital thinks the MSCI decision will not “rock the boat” for the A-share market. “The second largest market in the world, with a total market cap of US$7 trillion and daily trading volumes oscillating between US$50 billion and US$200 billion, [is] completely dominated by domestic investors [and] will hardly notice the US$12 billion of inflows that the MSCI decision implies in 12 months’ time,” says East Capital in comments after the announcement.

Select names that are perceived by domestic investors as “foreigner friendly” — high-quality companies with superior corporate governance standards in promising sectors such as services, healthcare and discretionary consumption — may enjoy a boost, says East Capital. But most of the gains may already be priced in, given that the 169 stocks eligible for inclusion in MSCI’s initial list have outperformed the market since the list was released on March 23.

Longer-term benefits Li of CSOP notes that in the longer term, there are other factors that have more bearing on a stock market’s performance, including corporate earnings, the economy and currency fluctuations.

Consider that Korea’s Kospi lost 8% of its value from the period that its inclusion was first announced to full inclusion, but the Taiwan Capitalization Weighted Stock Index saw gains of 15.2% during its period of inclusion.

Instead, benefits are likely to be reflected in the institutionalisation and rationalisation of the A-shares market. “[The inclusion] will, to some extent, help correct the valuation of large caps. In contrast to developed markets, where large caps enjoy higher valuations than small caps, thanks to lower risk and better liquidity, the price-to earnings ratios of China’s large caps are much lower than [that of] small and mid-caps,” says Li. “ Listed companies will also not suspend trading randomly; otherwise, they may be kicked out from MSCI’s basket.”

With this in mind, investors may want to consider taking a longer term bet on the A-share market. Exchange-traded funds with exposure to the 222 shares on MSCI’s list are the db x-trackers Harvest CSI300 Index UCITS ETF (DR) and the db x- trackers Harvest FTSE China A-H50 Index UCITS ETF (DR).

However, Lee of Schroders thinks an ETF may not be the best investment strategy. “We believe China’s A-share market is not fully efficient, and many of the best investment ideas are not well researched. Given the sheer scale of the market, it is therefore imperative to identify the most innovative, fast-growing and well-managed companies that will deliver shareholder value over the longer term,” he says.

Index-based ETFs have “significant exposure to large-cap stocks and tend to miss out on a meaningful level on small- and mid-cap stocks, where the most exciting growth opportunities origin ate,” Lee adds.

There are currently 10 ETFs on the Singapore Exchange that track MSCI indices with exposure to China. Of the 10, four by Deutsche Bank are delisting this month. None of the ETFs currently hold any of the 222 A-shares to be included.

Excluding the four to be delisted, the remaining six ETFs have returned an average of 15.1% yearto- date and 29.2% over a one-year period. According to SGX data, the best performer was the db x-trackers MSCI China Index UCITS ETF (DR), which captures the performance of large- and mid-cap stocks traded primarily in China and Hong Kong. It has returned 20.1% this year. In contrast, the Straits Times Index is up 13.4% in the same period.

With the inclusion of A-shares in the MSCI indices and easier access to the A-share market, should investors with stakes in H-shares now turn their attention to A-shares instead?

Li of CSOP thinks the MSCI inclusion does not mean that capital will necessarily flow from H-shares into A-shares. “A-shares and H-shares are different in many ways and investors need to consider which one suits them better,” she says.

“In the A-share market, there are many companies that are not listed in Hong Kong, such as some liquor producers. The liquidity of the A-share market is also much better than Hong Kong, given that the daily turnover on the Shanghai and Shenzhen main boards is more than RMB400 billion ($81.4 billion) while that on the Hong Kong mainboard is only HK$65 billion ($11.5 billion) to HK$80 billion.

“However, there is a daily trading limit of plus and minus 10% [of the stock price] on the mainland. In Hong Kong, there is no daily trading limit, and there are stocks that are not listed on the mainland, such as Tencent Holdings,” Li says.

Inclusion of A-shares in MSCI indices to boost China stocks over longer term

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