China's Weight in Emerging Markets

By Mark F. Toledo, CFA

June 12, 2018

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China's Weight in Emerging Markets

Building a global equity portfolio requires several levels of decisions- from defining the investable market to determining macro characteristics to selecting individual securities. China-registered companies present a special challenge for worldwide portfolios. Until recently, emerging markets mutual funds could only own B and H-shares of Chinese companies.

China opened its markets to foreign investors in the early 1990s with B-shares, which are shares of China-registered companies traded in foreign currencies. Regulators initially barred local investors from owning B-shares, though many found ways around the rules. B-shares were opened to domestic investors in 2001. H-shares of China-registered companies trade in Hong Kong, denominated in Hong Kong dollars.

Yuan-denominated A-shares of Chinese companies trade on mainland Chinese stock exchanges in Shenzhen and Shanghai. The A-shares market opened to foreign investors in 2003, but was limited to qualified institutions and subject to certain limits, including restrictions that made it hard to move money out of China. These limitations concerned mutual fund and exchange-traded fund managers, who must be able to meet daily buy and sell orders from shareholders.

More recently, restrictions have been eased. Since 2014, the Stock Connect program has linked the Hong Kong and mainland Chinese exchanges, making it easier for foreign investors to trade Chinese A-shares from outside the country. This program created cross-boundary investment channels whereby foreign investors could invest within certain limitations in some Shanghai and Shenzhen-listed A-shares via the Hong Kong Stock Exchange. In 2015, FTSE Russell, a provider of global benchmarks, started to include China A-shares in some of its benchmark indexes.

MSCI, another provider of global indexes, deliberated for several more years before adding China A-shares to its emerging markets, all-country world, and Asia indexes. The considerations focused on market volatility, accounting standards, the impact of speculators, and capital controls. China’s financial regulators relaxed limits on trading and moving money out of China, but analysts still worry that a sharp sell-off could trigger problems like those seen in 2015, when at one point many of the roughly 2,800 listed companies stopped trading.

This summer, MSCI started to include China A-shares in its emerging markets and China indexes. MSCI will add approximately 230 A-shares to the MSCI Emerging Markets Index by the end of August. The orange bar in the following table shows that the hypothetical full weight of Chinese companies in the MSCI Emerging Markets Index would be 42% if the full value of China A-shares are added to the index. The green bar shows that MSCI’s first stage of inclusion only increases the weight for Chinese companies to 31.6%.

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Index funds benchmarked to the MSCI Emerging Markets index must purchase the 230 China A-shares added to the index this summer to minimize tracking error. In contrast, Dimensional Fund Advisors can make its own decision about when to add A-shares and over what time period. The blue bar in the chart shows that Chinese companies represent 16.9% of the Dimensional Emerging Markets Core Equity mutual fund.

Dimensional has carefully evaluated the China A-shares market for a number of years. Members of the firm’s investment team have visited China and conducted meetings with market participants and regulators. Areas of evaluation have been wide-ranging, as avenues for accessing the A-shares markets have developed and changed over time. While Dimensional’s strategies do not rely on benchmark inclusion to determine either country or stock eligibility, benchmark providers’ country classifications represent an important consideration because many of its clients use indexes to make asset allocation decisions and evaluate performance.

Dimensional’s Investment Committee determines eligibility for countries, exchanges, companies, and share classes for each portfolio it manages. The portfolio management and trading teams provide input and monitor these countries and exchanges on a regular basis. The firm draws from multiple sources of information when making decisions about a country’s eligibility and classification.

In the near term, any decision on A-shares is likely to have a minimal impact on China’s weight in Dimensional’s Emerging Markets strategies. Dimensional will continue to assess potential changes and we will communicate any significant updates to you.

Mark F. Toledo, CFA is a Partner at Chicago Partners Wealth Advisors. He has been a wealth manager for over 35 years and has helped hundreds of individuals and foundations create better wealth management solutions.


IMPORTANT DISCLOSURE INFORMATION

Please remember that past performance may not be indicative of future results.  Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Chicago Partners  Investment Group LLC-“CP”), or any non-investment related content, made reference to directly or indirectly in this blog will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful.  Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions.  Moreover, you should not assume that any discussion or information contained in this blog serves as the receipt of, or as a substitute for, personalized investment advice from CP.  Please remember that if you are a CP client, it remains your responsibility to advise CP, in writing, if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services, or if you would like to impose, add, or to modify any reasonable restrictions to our investment advisory services. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing. CP is neither a law firm nor a certified public accounting firm, and no portion of the blog content should be construed as legal or accounting advice. A copy of the CP’s current written disclosure Brochure discussing our advisory services and fees is available for review upon request. Please Note: CP does not make any representations or warranties as to the accuracy, timeliness, suitability, completeness, or relevance of any information prepared by any unaffiliated third party, whether linked to CP’s web site or blog or incorporated herein, and takes no responsibility for any such content. All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly.

June 12, 2018

China's Weight in Emerging Markets

Building a global equity portfolio requires several levels of decisions- from defining the investable market to determining macro characteristics to selecting individual securities. China-registered companies present a special challenge for worldwide portfolios. Until recently, emerging markets mutual funds could only own B and H-shares of Chinese companies.

China opened its markets to foreign investors in the early 1990s with B-shares, which are shares of China-registered companies traded in foreign currencies. Regulators initially barred local investors from owning B-shares, though many found ways around the rules. B-shares were opened to domestic investors in 2001. H-shares of China-registered companies trade in Hong Kong, denominated in Hong Kong dollars.

Yuan-denominated A-shares of Chinese companies trade on mainland Chinese stock exchanges in Shenzhen and Shanghai. The A-shares market opened to foreign investors in 2003, but was limited to qualified institutions and subject to certain limits, including restrictions that made it hard to move money out of China. These limitations concerned mutual fund and exchange-traded fund managers, who must be able to meet daily buy and sell orders from shareholders.

More recently, restrictions have been eased. Since 2014, the Stock Connect program has linked the Hong Kong and mainland Chinese exchanges, making it easier for foreign investors to trade Chinese A-shares from outside the country. This program created cross-boundary investment channels whereby foreign investors could invest within certain limitations in some Shanghai and Shenzhen-listed A-shares via the Hong Kong Stock Exchange. In 2015, FTSE Russell, a provider of global benchmarks, started to include China A-shares in some of its benchmark indexes.

MSCI, another provider of global indexes, deliberated for several more years before adding China A-shares to its emerging markets, all-country world, and Asia indexes. The considerations focused on market volatility, accounting standards, the impact of speculators, and capital controls. China’s financial regulators relaxed limits on trading and moving money out of China, but analysts still worry that a sharp sell-off could trigger problems like those seen in 2015, when at one point many of the roughly 2,800 listed companies stopped trading.

This summer, MSCI started to include China A-shares in its emerging markets and China indexes. MSCI will add approximately 230 A-shares to the MSCI Emerging Markets Index by the end of August. The orange bar in the following table shows that the hypothetical full weight of Chinese companies in the MSCI Emerging Markets Index would be 42% if the full value of China A-shares are added to the index. The green bar shows that MSCI’s first stage of inclusion only increases the weight for Chinese companies to 31.6%.

Image

Index funds benchmarked to the MSCI Emerging Markets index must purchase the 230 China A-shares added to the index this summer to minimize tracking error. In contrast, Dimensional Fund Advisors can make its own decision about when to add A-shares and over what time period. The blue bar in the chart shows that Chinese companies represent 16.9% of the Dimensional Emerging Markets Core Equity mutual fund.

Dimensional has carefully evaluated the China A-shares market for a number of years. Members of the firm’s investment team have visited China and conducted meetings with market participants and regulators. Areas of evaluation have been wide-ranging, as avenues for accessing the A-shares markets have developed and changed over time. While Dimensional’s strategies do not rely on benchmark inclusion to determine either country or stock eligibility, benchmark providers’ country classifications represent an important consideration because many of its clients use indexes to make asset allocation decisions and evaluate performance.

Dimensional’s Investment Committee determines eligibility for countries, exchanges, companies, and share classes for each portfolio it manages. The portfolio management and trading teams provide input and monitor these countries and exchanges on a regular basis. The firm draws from multiple sources of information when making decisions about a country’s eligibility and classification.

In the near term, any decision on A-shares is likely to have a minimal impact on China’s weight in Dimensional’s Emerging Markets strategies. Dimensional will continue to assess potential changes and we will communicate any significant updates to you.

Mark F. Toledo, CFA is a Partner at Chicago Partners Wealth Advisors. He has been a wealth manager for over 35 years and has helped hundreds of individuals and foundations create better wealth management solutions.


Important Disclosure Information

Past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Chicago Partners Investment Group LLC (“CP”), or any non-investment related content, made reference to directly or indirectly in this commentary will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this commentary serves as the receipt of, or as a substitute for, personalized investment advice from CP. Please remember to contact CP, in writing, if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services, or if you would like to impose, add, or to modify any reasonable restrictions to our investment advisory services. CP is neither a law firm nor a certified public accounting firm and no portion of the commentary content should be construed as legal or accounting advice. A copy of the CP’s current written disclosure Brochure discussing our advisory services and fees continues to remain available upon request.