China has been a potent force in financial markets for more than a decade. Its impact on global economic growth has increased markedly. However, international investors own very little of its domestic stock and bond markets.
Following major market reforms, main index providers such as MSCI, FTSE and Bloomberg Barclays decided to include Chinese assets with a local listing in their flagship indices. In 2019, we have seen a noticeable increase in the weight of Chinese assets in these indices and further inclusion is likely.
So, is it time to give China its rightful share in your portfolio? The global multi-asset market portfolio is a good starting point for investors. This is the aggregate portfolio of all investors worldwide, with weights that reflect the composition of the average portfolio. It includes all free-float marketable assets in which financial investors have actually invested.
A common argument for increasing the weight of emerging markets or Chinese equities above the weight implied by their free-float market capitalization is the size of the economy. Measured by gross domestic product (GDP), these countries are much bigger than measured by freely floating market capitalization of equities: China accounts for a larger share of the global economy (15.8%) than the global stock market (3.7%).
The effect of multinationals
However, this is skewed by the fact that multinational companies are typically listed in the major financial centers in developed markets, such as the US, but contribute to global economic growth. An example is BMW, which has its primary listing in Germany while its revenues are truly global, with about 20% in 2018 coming from China and only 15% from Germany.
This involves not only BMW sales to Chinese customers; the company also produced close to 20% of its vehicles in its Chinese plants in Shenyang. By buying the shares of BMW, you would therefore obtain exposure to Chinese growth without being directly exposed to Chinese political risk and institutions.
Market cap versus revenue exposure
Source: MSCI, IMF (2012), Swinkels and Xu (2017).
So, the first reason to increase the weight to emerging markets seems flawed. Let’s take a look at a second. Emerging markets have a higher growth rate than their developed counterparts, which should lead to higher returns. While this argument sounds valid, some academics argue that the relationship between economic growth and equity returns tends to be negative instead of positive.
The effect of full inclusion
Which brings us to the key question: What should we do about China in view of its increasing weight in the indices? MSCI started to include China A-shares in its indices on a partial basis in 2018. Once China is fully included, it will be the third-largest market in the MSCI All Country Index after the US and Japan. The weight of China and the universe of other emerging markets would increase by almost 2% and China’s weight in the Emerging Market Index would rise by 10% to almost 42%.
Due to the increasing importance of indices in the investment industry, several researchers have investigated the financial economic consequences of changes in index constituents. The short-term price effect is typically positive. The demand for a share increases as new investors want or need to allocate to the share following inclusion. This effect is, however, not persistent. After obtaining their desired allocation, the temporary imbalance between demand and supply disappears.
A more persistent effect, however, can occur when investors assign positive sentiment to the inclusion and thus see it an improvement of the company. For example, a sign that governance is up to par as the company has met the criteria of the index provider. Hence, investors adjust their fundamental value.
Positive long-term effect
However, one reason to expect a positive long-term effect is that international investors are willing to accept lower returns than domestic investors. Where domestic investors are restricted to investing in only in the domestic market, they cannot benefit from international diversification. In contrast, international investors can benefit from this diversification, and therefore may be willing to pay a higher price, as their total risk will be lower than that of domestic investors.
As investors in China fall into the former category, one would expect China A-shares to trade at a discount (i.e. investors demand a higher return). In practice, we have witnessed the opposite. China A-shares that are also listed in Hong Kong have tended to trade at a premium in the domestic market.
So, are we giving China its rightful share? We believe that the global market portfolio is a good starting point for investors as it still holds a relatively small weight for China that is likely to grow going forward. In our view, the best approach would be to gradually increase allocation to China as the country continues to improve its governance and market reforms.
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