China’s equity market is large, deep and liquid

The market capitalization of China A-shares – companies listed on stock exchanges in Shanghai or Shenzhen – is around USD 8 trillion, second only to the US and around 30 per cent bigger than the euro area. But until China recently began making a concerted effort to open its markets, A-shares were purchased primarily by Chinese investors. Foreign investors have been more focused on the smaller H-shares market – stocks listed on the Hong Kong Stock Exchange – in large part because they were easier to access.

A-shares are coming to MSCI

By June 2018, a number of China A-shares are expected to be included in the MSCI Emerging Market Index for the first time. This is big news from what is effectively the world’s benchmark index for emerging-market stocks, and it sends an important signal about the credibility of A-shares. At the outset, MSCI’s initial A-share weighting will be small, with slightly more than 200 stocks added to the index. However, we believe this number will grow over time. MSCI has announced its plans to add more stocks in August, and investor interest is expected to be high: an estimated USD 18 billion is set to be allocated to China’s A-share markets.

Stock Connect is broadening the market

A key catalyst for the inclusion of A-shares in the MSCI’s EM index was the recent launch of China’s Stock Connect schemes – market-access programmes that enable investors to use their local exchanges to trade shares listed on cross-border counterparts. Stock Connect replaced the highly complex QFII and RQFII systems, which required non-Chinese investors to meet strict criteria to purchase A-shares.

High turnover adds to A-share liquidity

Domestic retail investors in China dominate the market for A-shares and account for more than 80 per cent of daily turnover. With the investment culture in China focused more on momentum and short-term trading, the stock turnover ratio of China A-shares is among the highest in the world. High levels of turnover generally make it easier for investors to buy and sell shares.

China A-Shares Have a High Turnover Ratio

Source: World Federation of Exchanges, Bank of America Merrill Lynch. Data are as at December 2016. Stock turnover ratio is calculated by total turnover divided by ending market capitalization.

An increasingly institutionalized market

Foreign investor ownership of China’s A-shares is growing, but from a low base – moving from 1.5 per cent to around 2 per cent of the market over the last year. Nonetheless, the A-share market is becoming gradually institutionalized, with an increasing number of large market participants making large-scale trades. The A-share market also features a significant number of “quality growth compounders” – high-quality firms that invest back into their businesses – that pushed the market higher in 2017. China’s domestic investors frequently ignore these aspects of an increasingly mature market, but foreign investors may be attracted to such steady signs of improvement.

Fewer stock suspensions

In July 2015, at the peak of a period of significant market instability, 51 per cent of listed China A-share stocks were suspended from trading. Today, that figure is only 8 per cent. New rules have been introduced to curb long and unreasonable stock suspensions, although the regulatory environment in China is unpredictable and continues to evolve.

A-Share Stock Suspensions Have Fallen Significantly

Source: Wind, Goldman Sachs Global Investment Research. Data are as at 23 Feb 2018.

A significant portion of the market is held by a small number of investors

As a result of the 2015 volatility, China formed a “national team” to help stabilize the market by purchasing A-shares. An estimated USD 544 billion in A-shares – approximately 7 per cent of China’s market cap – is still held by this group. As a result, China A-shares remain vulnerable to market intervention. However, this policy did boost stability: the volatility of China A-shares fell from 38.9 per cent in December 2015 to 11.4 per cent in December 2017.

Governance is getting better, though there is room for improvement

As in all emerging markets, corporate governance is a key issue in China, but things have been starting to change for the better. Approximately half of China A-share companies employ well-known international auditing firms. In addition, all listed Chinese companies are required to file quarterly reports and end their fiscal years on 31 December. Moreover, China’s generally accepted accounting principles have moved closer to International Financial Reporting Standards. However, it is still uncommon for Chinese firms to have English-speaking investor-relation departments, or to host overseas roadshows.

Investment professionals in China are less experienced

According to March 2018 data from UBS, China has approximately 5,000 equity-research analysts, and around 98 per cent of all covered companies receive a “buy” rating. There are also just over 1,600 portfolio managers in China, and they have only 3.1 years of experience on average. An overoptimistic, less experienced community may create opportunities for more seasoned investment professionals.

Lower correlations can bring benefits to portfolios

China A-shares have a correlation of less than 0.2 with global indices, and their correlation with Hong Kong-listed stocks is less than 0.5. This suggests that investing in A-shares could bring additional diversification benefits to portfolios. The gradual institutionalization of China A-share markets is expected to result in a higher correlation with their offshore counterparts, but this process could take many years.