Ahead of MSCI’s decision next Tuesday, 20 June on including China A-shares in the MSCI EM index for the first time, David Raper, Asia ex Japan portfolio manager at Comgest, the independent, international asset management group focused on quality-growth investing, comments on what this will mean for investors and analyses the risks associated with the decision:

“Including China A-shares in the MSCI EM Index is pivotal for the future of the emerging markets asset class and is a much needed acknowledgement of China’s efforts to open its domestic equity market to foreign investors. Today China is a dwarf in international equity indices. The MSCI index decision has the power to change that position and the decision is not a question of if, but when.

“The MSCI EM today ignores the Shenzhen and Shanghai stock exchanges, which represented 22% of global stock exchange turnover in 2016 or 50% of China’s market capitalization. Arguably the index does not fairly reflect the economic power of China and the breadth of its equity market. If it did and assuming full inclusion of A-shares into the MSCI EM, China would represent 40% of this index. In the long-term such a shift will transform the structure of the EM equity asset class simply because China will become very dominant.

“That said China is not a market for passive investors. The mainland China equity market offers all ingredients for alpha generation. Only 10% of the market cap is in the hands of professional investors versus 80% in Europe. The mainland China equity market is inefficient as evidenced in its record high share return dispersion. Index investors are, for example, fully exposed to the state owned enterprises of the Old China representing 50% of the mainland China market cap. An index exposure does not fairly reflect the opportunities of the rapid shift towards consumption and services in China.

“However, there are some risks to the index inclusion. MSCI ignores mainland Chinese equities for viable yet diminishing concerns on capital mobility as well as the high level of share suspensions. Those are the mirror image of China’s controlled capital account. The big picture, however, is that Beijing wants to internationalize the Renminbi, which ultimately means full convertibility of the currency not only for trade reasons but also for capital account transactions. The opening of China’s bond and equity markets must be seen in this light. The opening process is not easily reversible and thus should be considered a ‘tail risk’ rather than a base case scenario. Therefore, the risk to the index inclusion are real in 2017, but this risk will abate over time.”

Comgest has significant exposure to stock picks in China as well as to A-shares in particular. Its global emerging market fund, Comgest Growth Emerging Markets, saw its a-share weight rise from literally 0 in mid-2014 to 12% at the end of 2016. This exposure has been a strong contributor to relative performance of the CGEM fund over the respective time period.