Stocks trading in mainland China have long offered one of market’s biggest thrill rides—they’ve roughly doubled in just one year, only to give it all back the next—and they’re moving into the mainstream of fund investing.
Last week marked the first time that MSCI, a company whose indexes set the benchmark for many mutual funds and ETFs, included Chinese stocks called “A shares” in its widely followed Emerging Markets index. These stocks trade in Shanghai and Shenzhen and had been very difficult for outside investors to access, unlike shares traded in Hong Kong.
But mainland Chinese markets have been opening up in recent years, and MSCI added more than 200 A shares to its indexes, such as Hangzhou Hikvision, a video-surveillance company whose revenue has surged an average of 43% annually the last five years, and Kweichow Moutai, a premium liquor company.
This first move is a small one, relatively: A shares account for less than half of 1% of the MSCI Emerging Markets index. But a second phase of inclusions this summer will bump “A shares” up to 0.8% of the index, and more additions beyond that are likely.
The moves matter for all types of fund investors. Index funds that track the MSCI Emerging Markets index bought A shares so they can track the performance of the newly constituted index. The iShares MSCI Emerging Markets ETF, for example, is one of the most popular ways to invest in emerging-market stocks, and it now includes Hangzhou Hikvision and other A shares.
Actively managed emerging market funds aren’t required to buy A shares, but they will now have to compare their performance against the MSCI Emerging Markets index, which does have them.
Here’s a look at how A shares have performed and why they’re such a big deal.
How have these stocks done in the past?
They have a history of very big ups and downs.
In 2006 stocks in Shanghai more than doubled and then surged another 110% in 2007 in U.S. dollar terms. But they collapsed in 2008 amid the global financial crisis, plummeting nearly 63%.
One reason for the volatility is how dominated the market is by local retail investors. Unlike big institutional investors, who tend to dig into the financials of companies before deciding to buy, many of these retail investors piled into winning stocks on the simple expectation that they would keep winning. This helps lead to sharp booms and busts.
What risks are still there?
Even as institutional investors, such as mutual funds, increase their holdings of A shares, the retail-dominated market is still prone to big swings.
Plus, investors still see issues with corporate governance and how much influence the government has over the market. In 2015 when the A share market was tumbling in price, more than half the companies in the market had trading of their shares suspended.
“You’ve got something like 3,000 companies, and today we would think maybe 40 or 50 of them are investable,” Chuck Knudsen, emerging markets equity portfolio specialist at T. Rowe Price, said of the A share market. “It’s a very narrow list, though it’s widened over the last couple of quarters.”
Are things improving?
Yes, investors say. Companies are making more of an effort to engage with investors, particularly ones from outside China, for example.
“It’s just gradually improving over time,” said Andrew Mattock, portfolio manager at Matthews Asia. “You don’t wake up the next day, and everything is changed, but you see little things like companies’ investor relations having English as well as Mandarin materials.”
Why the interest in Chinese stocks?
As China’s economy, the world’s second largest, has shifted focus from heavy industry toward the country’s burgeoning consumer class, investors want to get into the companies that are benefiting from the rise of China’s middle class. Such stocks are more typically found in the A share market, Mattock said.
His Matthews China fund has about 11% of all its investments in the A share market, such as Angel Yeast, which is benefiting from growing demand in China for pizza and pastries, and Wuliangye Yibin, a liquor company.
The A share market is one the world’s largest and has more than 3,000 stocks.
How big a deal could A shares become?
The first inclusion of A shares in MSCI’s indexes may be more symbolic for fund investors than anything. Because they make up just 0.4% of the Emerging Markets index, their swings likely won’t bring noticeable day-to-day effects for funds. But their influence is likely to grow.
It took MSCI years to get comfortable enough to make this first step into the A share market, as it waited for the Chinese government to open the market to outside investors and make other improvements. This round will end up including just 5% of the total market value of the A shares in the Emerging Markets index. If China continues along its path, A shares alone could end up accounting for 16% of the MSCI Emerging Markets index.
“We will be talking more and more about the China ‘A share’ market in the years ahead,” said Knudsen of T. Rowe Price. “You know that Xi Jinping and the Chinese government want their currency to be the reserve currency. They want their economy to be the largest in the world. And they want their capital markets to be the largest in the world. We are quite certain they will do what it takes to draw investor dollars to those markets.”