Like it or not, many ETF investors are about to get an extra dose of China in their portfolios this year, thanks in part to index provider MSCI. U.S. Senator Marco Rubio is certainly not a fan of their decision. He has recently written to MSCI’s CEO, looking for answers as to why the company has included China A shares in their emerging markets indexes.
China A shares are securities of mainland China-based companies that trade on either the Shanghai or Shenzhen stock exchanges. These shares are denominated in Renminbi, which is the official currency of the People’s Republic of China. They were originally made available to domestic Chinese investors in 1990. Certain foreign investors have technically been able to purchase China A shares since 2002, but they have only recently become popular with index providers like MSCI.
In 2018, MSCI successfully included large-cap China A shares within their emerging markets indexes, at an index inclusion factor (IIF) of 5%. Translation: if the investable large-cap China A share market was worth $800 billion, MSCI pretended like it was only worth 5% of this value (or $40 billion) and adjusted the weight of China A shares within their indexes accordingly. This initial inclusion factor allowed MSCI to dip their toes into the China A shares pool, instead of requiring them to dive in head first.
At the time, this was a pretty big deal in the index community, even though the impact was relatively small. After the 5% inclusion, China A shares still only made up around 0.7%-0.8% of the MSCI emerging markets indexes.
In 2019, MSCI is set to quadruple this 5% large-cap inclusion factor to 20%, while also adding mid-cap China A shares, as well as large- and mid-cap ChiNext shares. They plan to implement these changes using a three-step inclusion process:
In the infographic below, I’ve estimated the impact each of the steps will have on the weight of China A shares within the MSCI Emerging Markets Investible Market Index (IMI).
In the event of a full inclusion of large- and mid-cap A shares, the total weight of China in the MSCI Emerging Markets IMI could hypothetically grow from around 29% now to just under 40%, and this assumes the foreign ownership limit imposed on China A shares will not change. The official foreign ownership limit for China A shares is currently 30%.
If your emerging markets equity, global equity, or asset allocation ETF tracks an MSCI index, chances are your fund could be affected by these changes. I’ve included a list of popular MSCI index-tracking ETFs that are expected to further increase their exposure to China A shares during 2019:
In my next blog, I’ll share excerpts from my interview with Craig Feldman, MSCI’s Managing Director and Global Head of Index Management Research, where he’ll discuss 2019’s three-step China A-share inclusion process in more detail.