Chinese A-shares, emerging markets, and the myth of passive investing

Do you hold an exchange-traded or tracker fund that follows the MSCI Emerging Markets Index? If you’ve been listening to the instructions issued by the investment industry on keeping costs low and diversifying internationally over the past decade, odds are you do. I wonder if you know what’s in it?

Most non-professional investors would, I suspect, assume that anything with “emerging markets” in the title is heavily weighted to China. They would be right: the index is 26% China. But I think they would also assume that some of the stocks in that weighting would be listed on the mainland. That would be wrong: the index does not include any “A-shares” (those traded in Shanghai and Shenzhen in renminbi) at all.

The good news is that this is about to change. MSCI, after four years of listening to lobbyists, has finally chosen 222 A-shares that it thinks make the index grade. Buy a product tracking the MSCI Emerging Market Index any time after next May and you’ll get a sliver of mainland China in the deal. This isn’t going to mean much immediate action: 222 is a tiny proportion of the available shares, and they will make up well under 1% of the index. But this tiny move has caused a disproportionate amount of comment.

China is pleased. The country with both the second-largest economy and the second-largest stockmarket – if you combine listings in Shanghai, Shenzhen and Hong Kong – now has its onshore markets considered to be emerging. China bulls are pleased. This might be no more than MSCI dipping a toe in China’s domestic waters, but if you are keen on something, its nice to think that a well-thought-of agency agrees.

But China’s bears are horrified. If you are of a “dystopian bent” as Jonathan Allum of SMBC Nikko puts it, this has to be the “classic top-of-the-market contrarian indicator”. As another investor put it to me, it is surely the final sign that global investors have gone “collectively mad”. After all, say the dystopians, given that the Chinese economy is quite clearly a vast Ponzi scheme represented by more of a trading jungle than a proper stockmarket – 80% of trading is done by retail investors – why would anyone anywhere cheer the further easing of its dodgy companies into the global financial system?

It is perfectly easy to take either side of this discussion. China does have an appalling debt problem: private sector, non-financial debt is not far off the levels seen in Japan just before its nasty 1989 bust. But debt is just the start of its problems: corruption, horrible air pollution, a worrying gender imbalance and, of particular concern to investors, endless government interference and awful corporate governance. Many A-share company managers “have yet to fully grasp the duties imposed by a listing”, says Hermes Investment Management. Anyone worried about the way the state might affect their investments in China need only look at this week’s news: shares in several big listed Chinese companies fell nastily as the banking regulator asked lenders to check the “systemic risk” in loans.

But there is an upside, too. The regulator’s demands tell us that the state is taking debt seriously. And you can make an excellent case that, for all the carping from the sidelines, China is making a normalish transition, as did Korea, Taiwan and Japan, from being a high-growth economy driven by exports, low wages and high infrastructure spending to a lower-growth economy based on high-end manufacturing, capital market liberalisation, rising wages and consumption. MSCI’s endorsement of China’s domestic markets tells us that good progress is being made on market access and governance. Everything might be just fine.

This is a fascinating debate. But it is not so much the search for the correct answer that should be exercising passive investors at the moment. They should worry that the debate exists at all. It is a neat reminder that the style of investing they think they have embraced does not actually exist. There is no such thing as passive. Someone has to decide what is an emerging market, someone has to decide which emerging markets are the most important and someone then has to decide which stocks define each emerging market.

So thanks to clear decisions made by MSCI you could soon be holding a reasonable amount of China’s domestic financial sector and a little of its discretionary consumer sector. And if you hang on to your investment for a decade you will probably find that your China weighting moves from 26% to 40% (if all A-shares were included).

That would be a substantial shift, which might be good and might be bad. The one thing it is not is neutral. If you choose an MSCI index to follow, you should remember creating that index involves both regular stock picking and regular asset-allocation decisions. Look at it like that and index investing does not make you a passive investor. As MSCI’s latest decision makes clear, it just means that you have effectively chosen MSCI to be your active manager.