If China joins the MSCI emerging markets index, we could make a lot of money

“That’s one small step for (a) man; one giant leap for mankind”, claimed Neil Armstrong, when he set foot on the moon in 1969.

During the same year, MSCI, the world’s leading financial index provider, with $9.5trn in assets to be benchmarked to its indices, launched its first global index, and changed emerging-markets investing forever. This index was followed in 1987 by the MSCI Emerging Market (EM) Index and in 2007 by the MSCI Frontier Market Index.

China’s A-Share market was set to be included in the MSCI Emerging Market Index – which would’ve been a huge boon for Chinese stocks. However, things stalled abruptly last week, with MSCI rejecting China’s application until several issues are resolved.

  • Passive investments such as exchange-traded funds (ETFs) want to have sufficient access to quotas to replicate their benchmarks.
  • Investors are concerned about capital lock up, the amount they’re allowed to repatriate and daily quotas under the Shanghai-Hong Kong Connect scheme.
  • And asset owners who use different accounts want to have clear titles of ownership of ultimate beneficiaries.

To pinpoint when these issues will be sorted out is tough. However, based on the speed things are happening in China it would be foolish to assume it can’t happen soon. My best guess is by 2017 at the latest.

So, let’s assume that China’s A-shares are eventually included in the index, and think about the effect of that development.

 This would change everything

To start, China’s inclusion in the MSCI EM Index would transform our assumptions of what constitutes emerging markets as an asset class.

At present, there is a proposal to start with a 5% inclusion factor, meaning that only a fraction of China’s total free-float market capitalisation would be accounted for. The effect would be a 1.3% weighting in MSCI emerging markets.

The effect of full inclusion would be gargantuan. Based on estimates by JP Morgan, China would account for nearly half of MSCI emerging markets. Of course, this is likely to take some time, as there is a 30% cap on foreign ownership in China.

Perhaps even more startling if there were to be full inclusion is that Asia – namely China and other regional stockmarkets – would constitute nearly 75% of the MSCI emerging-market index, rendering other regions more or less insignificant.

Another issue is that foreign portfolio managers would have to step outside their comfort zone and meet management teams and owners with minimal links to Western counterparts.

A third issue is timing the entry. The Shanghai and Shenzhen stockmarkets have racked up gains of 58% and 119%, respectively, this year. Valuations are challenging, with at price/earnings ratios of 25 times (Shanghai) and 77 times (Shenzhen), making it hard to know if it’s better to chase the momentum or wait for a pull back/crash.

A final consideration is how to tackle the initial public offering (IPO) market. Supposedly, the best way of investing in emerging markets is to buy growth stocks before everyone bids up the prices to their fair value. IPOs or small caps are favoured hunting grounds.

In China, IPO investing is currently a racy business, evident from the following set of statistics:

  • There have been 167 IPOs this year so far, raising $17bn
  • The average retail subscription ratio is 232 times
  • The average return for IPOs this year is 529%
  • The subscription price/earnings (PE) ratio was 23 times historical earnings, while current PE is 86 times 2015 earnings
  • The number of new accounts opened in April and May was 30 million

I’m still bullish in the long term

It is easy to feel whipsawed about China and its stock markets. I think that is unconstructive.

Trade offers a valuable perspective.

It took 15 years before China was granted membership of the World Trade Organisation (WTO) in December 2001. The membership brought real changes as China was forced to – or at least asked to – comply with global trading rules.

The result was astonishing. China turned into a supersized economy, which allowed foreign direct investors to reap huge profits.

The brouhaha around including A-shares in the index is likely to act as a similar catalyst, nudging China’s investment framework closer to its developed peers.

Foreign investors, faced with a world far from normal, should welcome such development…