Magazine issues » Summer 2015

INDICES: Patience is a virtue

GlyphsChina A-shares still await entry to MSCI’s Emerging Market Index, but the track is laid and a decision may be coming soon. George Mitton reports.

More than a few investors were expecting MSCI to add China A-shares to its widely followed Emerging Markets Index when it revealed in June the results of this year’s annual review. Accessing China’s capital markets has become easier since June 2014, with the Shanghai-Hong Kong Stock Connect, which launched in November, letting investors on the Hong Kong exchange buy mainland-listed shares directly for the first time.

On top of that, as MSCI acknowledged, the Chinese authorities have expanded the existing schemes – 12 cities now have quotas under the renminbi qualified foreign institutional investor (RQFII) scheme, compared with four a year ago – and clarified troublesome rules on capital gains tax.

So why did MSCI decide, once again, to wait? Despite improvements, access is still not free enough for MSCI’s institutional investor clients to assent to the addition of A-shares. But, a decision may not be far away, most likely in less than a year.

The limits China imposes on access schemes such as RQFII are still a sticking point. MSCI says its clients want more transparency over quota allocation, the flexibility to increase their quotas if they need to, and for China to allocate quotas according to how much money applicants manage.

This last point is understandable because the division of quotas, under the RQFII scheme at least, has not always been logical. Luxembourg, the largest fund domicile in Europe, got its first RQFII quota only at the end of April, for 50 billion renminbi ($8 billion), a sum described as “surprisingly small” by Z-Ben Advisors, a China-based consultancy. Doha, the capital of Qatar, received an RQFII quota in 2014 worth 30 billion renminbi, yet few funds are domiciled there. (Qatar does, however, have a large sovereign wealth fund and is a trading partner with China.)

Among individual asset managers, the distribution of quotas has not been even, either. In the same week as Luxembourg received its quota, Z-Ben Advisors noted that a new 10 billion renminbi award to the Australian unit of Vanguard Group had made the US-based firm the largest non-Chinese RQFII holder by some margin. In a statement published in early May, the consultancy wrote: “Among global passive product providers, Vanguard now dwarfs the rest of the competition: 66% more quota than Deutsche [Bank], 144% more than BlackRock, and 300% more than Samsung.”

It is understandable that asset managers want an equitable distribution of quotas and one that reflects the amount of money they each manage. For providers of passive funds, wiggle room is especially important. If a provider of exchange-traded funds (ETFs) is prevented by its quota limit from buying A-shares when it has to, its product will fail to track its benchmark.

Capital flows are not free even under the Shanghai-Hong Kong Stock Connect, which links the stock exchanges of Shanghai and Hong Kong. There is an aggregate quota of 300 billion renminbi on northbound trade (from Hong Kong to China) as well as a daily quota of 13 billion renminbi. Southbound trade is also subject to quotas.

These limits could prevent asset managers from buying as many A-shares as they wanted. Again, providers of passive funds such as ETFs would find this especially troublesome.

Jian Shi Cortesi, investment manager at Swiss asset manager GAM, says schemes such as Stock Connect “can digest only a certain amount of flows, and if all index providers announce an inclusion in short proximity, the potential for market dislocation could be quite large”.

In a conference call to explain MSCI’s decision, Remy Briand, MSCI’s managing director, said he wished to see China abolish quotas on Stock Connect. He said MSCI has set up a working group with the Chinese regulator, the China Securities Regulatory Commission (CSRC), which, among other things, would seek to increase the quotas.

“The total removal of the daily limit would be the best option, because the limit creates uncertainty,” he said. “Short of removing it, increasing it significantly would be a good thing.”

The third and final hurdle highlighted by MSCI was the question of beneficial ownership in the Stock Connect scheme. Although the Chinese regulator recently clarified the rules, MSCI says investors will need time to become comfortable with them.

“Because they typically delegate investment and operational decisions to their fund managers, recognising clear title to ownership for the ultimate beneficial owners is a crucial concern,” says MSCI, in a statement.

The encouraging news is that MSCI does look likely to add A-shares soon. Briand says the addition may happen outside the regular schedule of its index review – a strong hint it will take place before next June. The working group was a clear sign of progress, he said, though he added it was “not a formal body, but a mechanism to get to a faster resolution”. He was a little vague on the arrangements of the group, but said it would meet both in person and on conference calls.

In the meantime, investors who are eager for A-share exposure can get it with MSCI indices. In June 2014 the firm launched the MSCI China A International Index, which can be combined with its emerging market index to approximate the opportunity set, were A-shares to be included in the latter index.

Alternatively, investors can turn to FTSE Russell, another index provider, which recently launched two “transitional” indices that include a roughly 5% weighting to A-shares, which will increase to around 32% over time. Vanguard Group announced it would switch its $69 billion Vanguard Emerging Markets Stock Index Fund to one of the new indices. Vanguard’s large RQFII quota may give it confidence it can buy enough A-shares to match the index.

Few doubt that flows into China will increase as the markets become more accessible. A paper commissioned by the Depository Trust & Clearing Corporation (DTCC) in the US recently predicted international holdings of A-shares would rise to $428 billion by 2017.

“Because they are committed to opening China’s capital account, regulators can be expected to expand quotas to meet investor demand,” says Neil Katkov, senior vice president at Celent, the research firm that wrote the DTCC-commissioned paper.

As mentioned, any changes to the MSCI index will affect passive funds most immediately, because they will be obliged to alter their allocations as soon as the index change is made. Many active fund managers, however, also benchmark their funds to MSCI’s indices, which is why these decisions affect them as well.

But should they care? Some argue the attention paid to indices is illogical.

“Several times a year, markets get very excited about the inclusion of various countries in various indices. Today it is A-shares,” says Mike Sell, head of Asian equities at Alquity Investment Management, an asset manager that focuses on responsible investment. “This is to completely miss the point of investing.

“Investors need to return to basics – ask themselves, ‘Do I want to buy this company?’ – and not be swayed by overhyped silliness such as this.”

©2015 funds global asia

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