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China A-shares' 4x weight increase in MSCI EM Index: implications for index investors
On 28 February 2019, MSCI announced the expected increase of China A-shares' weight in MSCI Emerging Markets Index to over 3.3% from the current 0.8%.
- MSCI announced the (largely expected) results of its consultation on China A-shares' further weight increase in MSCI Emerging Markets Index: as per its proposal, MSCI will increase China A-shares inclusion factor to 20% from the current 5%, i.e. China A-shares weight will rise to 3.3% from the current 0.8%*.
- In addition to the stocks in the current eligible universe (large caps listed on the Shanghai or Shenzhen HK Stock Connect), mid-caps and ChiNext stocks will now also be in scope. ChiNext is a board on the Shenzhen Stock Exchange that aims to attract innovative, fast growing especially in the high tech sector. As a reminder, the advantage of the HK Stock Connect, which links Hong Kong with Shanghai and Shenzhen, is that it allows international investors to trade China A-shares in Hong Kong without the same restrictions they would face buying shares on the mainland using renminbi.
- Implementation will take place at three steps: at the MSCI index reviews in May, August and November 2019.
- Estimated aggregate trade for index investors at the three-step inclusion process is c. USD 13 billion, which, at each of the three steps, we do not envisage to create a signify market impact.
- In September 2018, a day before FTSE Russell announced the initial inclusion of China A-shares in FTSE Emerging Index (at 25% investability weight) as part of the FTSE Annual Country Classification Review, MSCI opened a consultation on the further weight increase of China A-shares in MSCI Emerging Markets Index.
- We participated in the consultation, and were largely supportive of the proposed weight increase. As per the consultation proposal, MSCI will increase the weight of China A-shares in MSCI Emerging Markets Index to 3.3% (20% inclusion factor) from the current 0.8% (5% inclusion factor) in three steps: at the May, August and November 2019 index reviews.
- In addition to the stocks in the current eligible universe (large caps listed on the Shanghai or Shenzhen HK Stock Connect), mid caps and ChiNext stocks will now also be in scope. The first two steps will see the weight of large caps (including ChiNext stocks) increase, while at the third step both the weight of large caps will increase and mid caps will be added for the first time. On completion of the three-step implementation, there will be 253 large cap and 168 mid cap China A-shares, including 27 ChiNext stocks, representing 3.3% index weight. There are currently 234 China A-shares representing 0.8% index weight.
- As a reminder, the Shanghai or Shenzhen HK Stock Connect provide foreign investors an access to a selection of large and mid cap China A-shares, without QFII/RQFII licence, but with a daily limit on aggregate traded value on the HK Stock Connect Exchange. The latter restriction was mitigated materially in 2018, when the daily net buy quota quadrupled.
Implications for index investors
- Market impact: USD 2.3 trillion are estimated to track MSCI Emerging Markets Index, both on an active and passive basis, of which c. USD 500 billion* are estimated to be in index assets (source: MSCI). A 2.5% weight increase of China A-shares would imply a c. USD 13 billion aggregate trade for index investors at the three-step implementation: c. USD 3.5 billion estimated trade at each of the first two steps, and c. USD 6 billion trade at the third step. Each of the three trades represent c. one day's average trading volume, which, on its own, would be unlikely to create a significant market impact. However, as the initial inclusion of China A-shares in FTSE Emerging Index (at 25% investability weight) will take place over similar timeframe (three tranches in June and September 2019 and March 2020), we would envisage increased demand for this basket of stocks.
- Investor impact: As with the initial inclusion of China A-shares to MSCI EM Index in 2018, index investors would not need to secure a quota and/or investment vehicle with a quota (e.g. pooled fund or ETF) with this phase of inclusion. Investors would need to keep in mind that the projected 421 A-shares in MSCI Emerging Markets Index would have only c. 3.3% aggregate index weight, therefore, we would likely continue to apply stratified sampling in the relevant index equity portfolios to minimise transaction costs.
- Weight increase of China A-shares beyond 20%: MSCI have said that future weight increase of China A-shares in MSCI EM Index would require Chinese authorities to address the remaining market accessibility concerns, including:
- Lack of suitable derivative instruments: the current absence of exchange traded index futures hampers the efficient implementation of index portfolios.
- Short settlement cycle: the T+0/1 settlement of China A-shares is sub-optimal from operational and index tracking perspective in the context of the MSCI EM Index where the other constituent markets operate on a T+2/ T+3 settlement cycle. In January this year we met with representatives from the Shanghai Stock Exchange (SSE), and one of the topics we discussed was the T+0/1 settlement, expressing our view that aligning China A-shares settlement cycle with other markets would be a positive step.
- HK Stock Connect trading holidays: misalignment between onshore China and HK Stock Connect holidays continues to create investment friction.
UBS Indexing experience
(data as at 31 December 2018)
- Over 30 years' indexing experience, USD 308 billion AUM, tracking over 150 indices.
- Over a decade's experience in managing emerging markets index equity with AUM of over USD 15 billion.
- Big enough to benefit from economies of scale, but not too big to face liquidity constraints when trading for index changes.
- Building upon the experience of the broader UBS Asset Management: experience in all operational aspects of managing emerging markets mandates, over 20 years' China equities investment experience.
- HK Stock Connect daily quota quadrupled.
- QFII quota doubled
- The China Securities Regulatory Commission launched a consultation to harmonise and further relax the QFII/RQFII schemes.
- SSE introduced MOC.
- Voluntary stock suspension rules have been tightened further.
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