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Markets & Regions: China unleashed: taming the dragon through ETFs

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Despite its favourable fundamentals and widely acknowledged growth potential, China continues to be under-owned by most global investors. 

China is currently ranked as the world’s largest economy on a number of metrics, including purchasing power. Its equity market is liquid and deep. The impact of these factors, along with the country’s inclusion in the MSCI and other major equity indices, should not be underestimated.

This article aims to provide an overview of China and China-A Inclusion ETFs. We also discuss why investors should consider the access these ETFs offer to China, as well as the key considerations to help choose the right ETF strategy and issuer. 

Journey towards inclusion 

The addition of domestic Chinese equities (‘A-shares’) to global indices has been in the news for more than half a decade. The key concerns that passive investors had prior to Chinese stocks’ index inclusion centred on the availability of direct and simple access to the Chinese equity market, the capital controls imposed on international investors and a lack of clarity regarding the beneficial ownership of stocks held. 

These concerns were removed with the introduction in 2014 of the Hong Kong (HK) Stock Connect trading mechanism and clarification by the local regulator and exchanges regarding foreign investors’ beneficial ownership status. In order to assuage concerns around capital controls, MSCI has limited index additions to securities within the Stock Connect scheme, which is important as the trading mechanism has many benefits for international investors.  

MSCI started to include China large-capitalisation shares in the MSCI Emerging Markets index on 31 May 2018. MSCI was originally planning to include both mid-size and large cap China shares; however, following extensive consultations with investors and beneficial owners, this was reduced to only large-cap stocks and only those tradeable via the HK Stock Connect route. This addressed concerns related to the stock suspensions prevalent in the Chinese equity market at the time, which generally impact small- to mid-size companies. 

Following the successful inclusion of the first two tranches of Chinese large caps, MSCI announced that it would further increase the inclusion factor and add China mid-cap shares as a result of enhancements to the inclusion criteria. Under the current partial inclusion plan, China-A shares will have an inclusion factor of 20% in 2019 (split into three phases). In the event of full inclusion (a 100% inclusion factor), Chinese equities would exceed 40% by weight of the MSCI Emerging Markets index.  Regardless of the timetable for full inclusion, the key for investors is understanding that any emerging market fund tied to the MSCI Emerging Markets index will see a significant jump in its exposure to China.

In the absence of a detailed understanding of the operational nuances of setting up access to Chinese equities, it may be preferable for investors to gain access via an ETF that offers exposure to A-shares and removes the cost and complexity associated with investing directly. The MSCI China-A Inclusion index is designed to track the progressive inclusion of A-shares in the MSCI Emerging Markets index. An ETF which is benchmarked to this index is the perfect vehicle to gain fast and cost-efficient access to this section of the market.

Traversing a competitive market

While there’s a vast choice of ETF issuers covering Chinese equities, there are a number of key considerations for an investor considering a China ETF:

● Which replication technique does the ETF issuer adopt – physical or synthetic? Synthetic ETFs tend to have lower tracking error compared to their physical counterparts but are not as transparent when it comes to tracking difference or the risk taken (due to swap spreads and transaction costs). Any increase in derivative exposure via swap transactions increases exposure to counterparties, which doesn’t exist with physical replication.  

● If the fund is using a full physical replication technique, does the issuer have the capabilities to effectively replicate the index?

● How long has the issuer been issuing ETFs and other index tracking products? A demonstrable tracking error history can help with calculating the total cost of ownership.

● Can the issuer demonstrate understanding of the local market from a regulatory, operational and trading perspective?

Knowing the local market: minimising execution costs

Local knowledge in China is key. This can be demonstrated through the most recent inclusion in the MSCI August 2019 reconstitution. In some cases, the new China A-share index members represented a significant portion of average daily volume both historically and on the index inclusion day. This meant that only with on-the-ground networks and deep knowledge of the market could the rebalance be traded with successful execution outcomes and subsequently good fund performance, resulting in low tracking error for investors. The China A market has ample liquidity, but identifying the outlier stocks at these inclusion points in a timely manner helps the portfolio construction, implementation and subsequently the performance of an ETF. It’s all about going that extra mile to improve performance rather than blindly replicating the exact implementation by the index, which is essentially just a set of rules.

If not controlled effectively, trade execution costs in passive portfolios can begin to be a significant source of performance drag.  By identifying and taking advantage of efficiencies in execution methods, such as sourcing natural liquidity, diversifying trade timing and negotiating very low execution commissions, investors benefit from reduced costs and a boost in performance. As an example, by improving trading performance, HSBC has been able to reduce execution costs in 2018 by circa 42%.1 

In conclusion, China’s evolution, accompanied by the partial index inclusion of A-shares, has generated positive sentiment. Now that the first phase of the inclusion is complete, investors may wish to seize the opportunity to get ahead of the rebalancing crowd to increase their exposure to this exciting market. An ETF tracking the MSCI inclusion index is the perfect vehicle for achieving this. However, the right ETF provider must also have the capabilities to effectively replicate the index, as well as demonstrable experience and on-the-ground expertise from a regulatory, operational and trading perspective.

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