What sort of asset allocation makes sense following MSCI's decision to admit mainland China A-shares into certain global indices?
A recent decision by Morgan Stanley Capital International, or MSCI as the index-provider firm is known, to allow mainland Chinese shares to be used in emerging market indices from next year will, so wealth managers say, herald a major asset allocation shift over the medium term. It is part of a series of moves Beijing is making to open up to international capital, mindful perhaps that the country continues to need such access and strike a broadly welcoming approach to foreign money.
So far, as previously reported by this publication, response from the wealth management sector has been broadly favourable. The move could be seen alongside developments such as the “connect” links for Hong Kong/mainland China bond/capital markets that have taken shape, the inclusion of China’s renminbi in the IMF’s Special Drawing Rights currency basket, and widening of investment quotas for foreign qualified investment firms.
In this article, Tim Atwill, head of investment strategy at Parametric Portfolio Associates, a firm with $176 billion in assets under management. It is headquartered in Seattle, US, with other offices in the country as well as Australia. The editors here are pleased to share these views and invite responses; they don’t necessarily endorse all views of guest contributors. Email firstname.lastname@example.org
This week MSCI made the decision to begin including Chinese A-shares (those listed on mainland exchanges) in their Emerging Markets (EM) Index starting in mid-2018. Parametric has long argued against this inclusion, primarily on the basis of how large the allocation can grow, given the various access and investor protection issues these markets present. This recent decision by MSCI, which seemingly goes against their own provisions for index inclusion, has done little to change our minds.
When making their recent decision for the inclusion of A-shares into their index, it appears that MSCI primarily focused on the size of the Chinese marketplace, rather than on the lack of investor access and protections. Indeed, in its 2016 review, MSCI set forth three obstacles to inclusion of A-shares: restrictive repatriation limits, lax trade suspension provisions, and pre-approval requirements for financial products linked to A-shares. They stated these obstacles needed to be addressed in order for progress inclusion to occur. However, the recent inclusion proceeded despite none of these obstacles having been remedied. MSCI offered only bland assurances that this decision had the support of international investors.
It is only fair to note that Parametric does hold A-shares in its Emerging Markets strategy. This inclusion followed a boisterous debate, where we considered the pros and cons of including A-shares in a diversified emerging markets portfolio. On the plus side, A-shares have historically demonstrated low correlation with Hong Kong listed shares, as well as the equities of other emerging market countries, yielding a diversification benefit to the broader portfolio. Also, the A-share market allows an investor access to a broader representation of economic sectors within China then available from non-mainland exchanges. On the negative side, there exists material currency repatriation risk with respect to the Chinese yuan, and market access and investor protections are extremely primitive when compared to other emerging markets.
While these negatives are a concern, underdeveloped market conditions on their own do not disqualify A-shares from inclusion in our strategy. Our firm has invested in the least developed capital markets for over twenty years, incorporating static allocations to a large number of frontier market countries. If we re-frame the A-share decision as, “are Connect-listed A-shares riskier than a frontier market country,” it is obvious that they are not. However, as past events have demonstrated, they are also not substantially less risky. By treating A-shares like we would any other frontier market (which we believe is the closest analogy), we believe a small position (roughly 1-2 per cent) best balances the diversification benefit of A-shares with the inherent political, economic and liquidity risk one takes on when investing in mainland exchanges. It is with regards to this sizing decision where we stand in strongest opposition to MSCI.
As it stands, the current inclusion plan from MSCI starts with an allocation to A-shares of about 0.7 per cent in the MSCI EM Index. Then as market conditions are liberalized, this allocation grows to as much as 15-20 per cent. While this initial allocation appears appropriate, as it increases investors would be well-served to make sure that they are in agreement with the assessment of the index providers. If not, they should move to either a benchmark, which excludes A-shares (MSCI currently states they will continue to provide such an index) or to a strategy whose A-share sizing best reflects their opinion. To do otherwise would amount to blindly accepting a major allocation to a market, which has historically shown little interest in the rights of foreign investors.
About the firm:
Parametric offers a variety of rules-based investment strategies, including alpha-seeking equity, alternative and options strategies, as well as implementation services, including customized equity, traditional overlay and centralized portfolio management. Parametric is a majority-owned subsidiary of Eaton Vance Corp. and offers these capabilities through investment centers in Seattle, WA, Minneapolis, MN and Westport, CT.
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