As the A-share market is opening up to investors and MSCI has just taken its first step to include A-shares, a lot of capital is expected to flow into the onshore Chinese market. Besides this tactical reason to invest in Chinese A-shares, they merit a longer-term allocation as well. Here are five reasons why Chinese A-shares should be part of a portfolio’s strategic allocation.
The Chinese A-share market, i.e. the Shanghai Stock Exchange and the Shenzhen Stock Exchange combined, constitutes the world’s second largest equity market after the US. Its market capitalization is approximately USD 8.8 trillion.
To foreign investors, the A-share market has effectively been a sleeping giant, which has largely been ignored. Up until now this made sense, given the market’s closed nature, but now that it is opening up, investors can no longer afford not to make a conscious decision about whether they want to invest in this market or not.
This year, MSCI is including Chinese A-shares in the MSCI Emerging Markets Index, starting with a 5% inclusion factor. This is an important step, as it is expected to support the renminbi and improve the A-share market’s investor structure from retail-dominated to a more balanced mix of institutional and retail investors. Furthermore, the inclusion will likely improve China’s capital market liberalization and regulation. Full inclusion will take five to ten years, depending on progress in market accessibility.
A-shares’ inclusion in relevant indices means that, as of now, not investing in them is an active decision, which for index-aware investors comes down to taking an active underweight position.
The Chinese A-share market accounts for 70% of the market capitalization of all Chinese listed stocks. It offers investors even more diversification potential than offshore H-shares: among the 15 key sectors, there are ten sectors with over 70% of their market capitalization listed in China A-shares only.
The market offers exposure to state-owned enterprises (SOEs). These stocks, although often in old economy sectors, are expected to make significant progress in terms of mixed-ownership reforms and improved corporate governance. Some sectors that make up the ‘new economy’, like healthcare, consumer products, services and technology, as well as the Industrial Upgrade theme are showing better growth than the market as a whole. They account for about 40% of total A-share market capitalization.
The Chinese A-share market has a low correlation with global equity markets (see table 1). One important reason is that it is still largely driven by local retail investors, who hold over 50% of the market’s total free float market capitalization and account for 87% of total trading volume. Retail investors tend to have a shorter-term investment horizon and behave differently from institutional investors.
A second reason is that the market has been closed to foreign investors for a long time and is only gradually opening up. True, this will eventually increase the market’s correlation with other equity markets, but this will take time. Currently, 2% of market capitalization is foreign-owned, against 31% for Japan and 20% for the US.
The Chinese onshore stock market did not open until 1990 and has only gradually been admitting foreign institutional investors since 2002. This market is set to grow further as corporate earnings improve, more companies are listed, and A-shares are becoming more broadly available to global investors.
Table 2 lists the returns on Robeco Chinese A-share Equities since inception in March 2017 and the MSCI China A International index. As the track record shows, the A-share market’s structure and predominantly retail ownership offer substantial alpha opportunities. As this will only change gradually, these opportunities will be around for quite some time.
Chinese A-shares are becoming increasingly important for global investors. There are five good reasons why they should be part of a strategic core allocation in a portfolio. Of course, like any other market, it is not a bed of roses either. It’s important to monitor the market closely, and changes in factors such as valuations and earnings will require tactical portfolio adjustments. This however does not detract from the strong case for a long-term, strategic position in Chinese A-shares.
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