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MSCI Emerging Market Index and Chinese A shares

Sigma Investment Counselors

June 16, 2016

Investors will run across the initials MSCI and wonder, what is MSCI?  MSCI Inc. is a U.S. based company that compiles and publishes a series of indices such as the MSCI World Index and is the largest indexing firm in the world.   For example, the MSCI Emerging Market Index is used by global investors as a benchmark to measure returns and structure portfolios.  The index consists of 23 countries and represents 10% of world market capitalization.  Currently, the global assets tracking the MSCI Emerging Market Index total $1.5 trillion.  However, the index does not include Chinese class A-shares.   “A-shares” refer to yuan-denominated Chinese stocks trading on mainland stock exchanges and generally are unavailable to overseas investors.  Including Chinese A-shares in the emerging market index would bring tens of billions of dollars into China’s mainland stock market.

On Tuesday, MSCI announced that for the third time they will postpone adding mainland Chinese stocks to their emerging market index.  MSCI said the decision is based on investor concerns over Chinese capital market mobility and transparency.  Although Chinese authorities have relaxed restrictions on foreign capital participating in the local stock market, it still has policies in position that limits foreign capital being removed from China.  For example, the maximum monthly foreign capital repatriation is 20% of their net investment.  This is a critical issue for mutual funds and ETFs, which have to meet daily demands for investments or redemptions.

MSCI has been considering adding Chinese A-shares to its emerging market index since 2014.  As discussed in a recent WSJ article, after last year MSCI’s rejection, the Chinese stock market fell 40%, and $600 billion of market value evaporated over the weeks following.   Currently the Chinese stock market has disregarded the negative news and rose 1.6% after the announcement.  One possible explanation for the lack of market response is that Chinese A-shares are listed on the Hong Kong stock exchange and overseas and as such are included in the MSCI Emerging Market Index, representing 25.9% of the entire index.  If MSCI had agreed this time, their initial target weighting was 1.1% of the index; however, if the percentage allocation was purely based on market capitalization, Chinese A-shares should represent roughly 18.2% of the emerging market index.

MSCI said it would review China A-shares again in June next year, but did not rule out a potential inclusion before then should Chinese authorities step up their reform efforts.

All comments and suggestions are welcome.

Wenny Gorman, CFA®

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