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A-Shares: The long march (to full inclusion)

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      By Jean-Christophe Lermusiaux, Emerging Markets Portfolio Manager, Hexavest

      Montreal - Reading headlines about A-Shares have recently become a daily routine for investors interested in Chinese equities. With the gradual inclusion of these shares in the MSCI Emerging Markets (MSCI EM) and MSCI All-Country (ACWI) indexes, the pace of foreign institutional flows is intensifying. Is this just a frenzy or are we dealing with a more durable trend? Here are the key factors our Emerging Markets team considers when investing in A-shares.

      A-shares are mostly driven by domestic players and retail investors

      A-shares refer to shares of companies based in China mainland listed on either the Shanghai or Shenzhen stock exchanges. These shares are quoted only in China's currency, the renminbi. There are two other classes for Chinese equities: the B‑shares, which are listed in foreign currencies and have been opened to qualified foreign institutional investors since 2003 (QFII), and H‑shares, which are issued in Hong Kong by mainland companies and listed in Hong Kong dollars. In practice, foreign investors have only been able to purchase A-shares since last year. As of the end of March 2019, China's central bank estimates that foreign investors own only about 2.6% of the A‑share market.

      One of the consequences of the Chinese authorities' fight against capital outflows is that Chinese investors have been refrained from investing in Hong Kong, which means that they have overly concentrated their investments in A-shares (and real estate, but this is another matter). Another characteristic of the Chinese equity market is that individuals (i.e. retail) make up a large portion of the A-share investor base; institutions typically have a bigger weight in developed markets. Morgan Stanley estimates that as of Q1, retail investors held over 50% of total free-float market cap in Chinese A-shares and contributed north of 80% to the A-share market's daily turnover.

      A-shares also offer a diversified and more appealing set of opportunities than B- and H-shares. There are about 3,600 stocks listed on both Shanghai and Shenzhen, compared to 2,800 on the New York Stock Exchange and 3,300 on the NASDAQ. Typically, foreign investors have been attracted to H-shares, a market heavily geared toward financials and internet-related stocks. The A-shares market is well-diversified in terms of sectors and industries, and much less geared toward internet-related stocks.

      So far, most of the largest Chinese technology-related companies (Tencent, Alibaba, Baidu) have raised funds abroad and are listed offshore. This does not fit the Chinese authorities' goals, as they would like to create a buoyant technology sector in mainland China, capable of raising funds locally (and, therefore benefiting local investors). In our view, there will be a strong push to list startups and so-called unicorns on either ChiNext (China's closest equivalent to the NASDAQ) or on the newly announced Shanghai tech board. This will likely be a driver for the Chinese market over the next few years.

      A long but seemingly unavoidable inclusion in the MSCI EM Index

      The debate about the pros and cons of including A-shares within the MSCI EM Index has been lingering for a couple of years. A-shares are now the second-largest market in the world in terms of market capitalization, thus becoming too big to ignore.

      Hexavest Chart 1

      What is changing in 2019 and the implications

      At the end of February, MSCI decided to further increase the weight of A-shares in the MSCI indexes in three steps. The timeline and road map for this year is:

      June: Doubling the China A large-cap inclusion factor (or weighting) from 5% to 10% and adding ChiNext large-cap shares with a 10% inclusion factor.

      September: Increasing the inclusion factor of all China A large-cap shares from 10% to 15%.

      December: Increasing the index inclusion factor of all China A large-cap shares from 15% to 20%; adding China A midcap shares, including some ChiNext shares with a 20% inclusion factor.

      Hexavest Chart 2

      Bottom line: The weight of A-shares (currently 0.8% of the MSCI EM Index) should hover near 4.0% by year-end. To put things in perspective, the weight of A-shares alone would be larger than the weighting of Poland by the end of June, Malaysia by September and Russia by December. Morgan Stanley estimates that the 2019 A-shares index inclusions by MSCI and FTSE Russell should bring substantial foreign inflows, ranging from US$70 billion to US$125 billion in 2019.

      About Risk: The value of equity securities is sensitive tostock market volatility. Investments in foreign instruments orcurrencies can involve greater risk and volatility than U.S. investmentsbecause of adverse market, economic, political, regulatory, geopolitical,currency exchange rates or other conditions.

      MSCI data may not be reproduced or used for any other purpose. MSCI provides no warranties, has not prepared or approved this report, and has no liability hereunder.