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There's a new component to the MSCI emerging markets indexes as of June 1: Chinese A-share stocks. A-shares are shares of mainland China-based companies that are traded on the Shanghai Stock Exchange and the Shenzhen Stock Exchange in local currency. The addition of these shares to MSCI's widely followed indexes is expected to spur billions of dollars in foreign investment in the Chinese market.
Though China's market capitalization is second only to the U.S., the risks and complexities of investing there are much different than in other emerging markets countries. For investors considering their options, here are 10 things to keep in mind:
China's $9-trillion stock market represents 14 percent of the global market.1 This includes the vast $6-trillion domestic market, with the remaining $3 trillion traded offshore in the U.S., Hong Kong and Singapore.
According to McKinsey & Company2, more than 75 percent of China's urban population will be considered middle class by 2022, while 54 percent will be deemed upper-middle class. As the upper-middle class expands, Chinese consumers are expected to spend more on higher-quality daily staples, such as food and clothing, as well as housing, cars, entertainment, health, education, and luxury goods.
While companies incorporated in China can issue three different classes of shares, most are A-shares, which are listed on Chinese exchanges in local currency. They account for about 65 percent of the domestic stock market.
China A-shares have historically been inaccessible to foreign investors, but the Chinese government has opened its capital markets in recent years. It has launched a series of initiatives to allow institutional investors to purchase A-shares, including a new program kicking off this year.
With a market share nearly 30 percent, financials are the largest China A-share sector. This includes several state-owned banks and insurance companies. Industrial companies and makers of consumer discretionary products also represent large sector positions. Unlike the U.S., where information technology makes up roughly a quarter of the S&P 500® Index, IT represents only about 9% of the A-share market because most Chinese technology firms are listed in the U.S. and Hong Kong.
More than half of China's A-share companies are state-owned enterprises (SOEs) whose executives are appointed by the government. As such, public policy objectives may override the profitability of these companies, especially in sectors where the government desires more oversight. As a result, the high level of exposure to underperforming SOEs in an index may make a purely passive approach to investing in China less efficient. Our research found that SOEs are generally less efficient, less profitable, more expensive, and more leveraged than their peers.
Though the market is liquid, investors occasionally face liquidity constraints. For example, trading can be halted before announcements of certain important news. Investors also must contend with a circuit breaker rule that halts trading in an individual stock for the day if the price moves plus or minus 10 percent. When the market is under stress, a large segment of the companies traded can hit this limit, creating a severe liquidity constraint.
Unlike the U.S. stock market, which is dominated by institutions, China A-share trading is dominated by retail investors who hold more than 75 percent of the market—excluding the shares held by insiders. Retail investors may often be irrational, making buy and sell decisions based on emotion and speculation rather than fundamentals. In addition to creating heightened volatility, irrational behavior can cause individual stocks to become mispriced, creating opportunities for skilled active managers.
Chinese companies experiencing repeated losses are subject to "special treatment" by regulators. A company is required to add "ST" before its original share name if its net profit is negative over two consecutive fiscal years. ST companies face tighter circuit breakers and are more closely supervised by auditors, making them less attractive to investors. As a result, distressed companies in China tend to manipulate their earnings and cash flows to avoid special treatment.
Companies listed outside mainland China also offer access to this growing economy. Examples include the BATs—Baidu, Alibaba and Tencent—which are listed on U.S. and Hong Kong exchanges. They are considered by some investors to be the Chinese equivalent of the U.S. FANGs—Facebook, Amazon, Netflix and Google. Another way to gain exposure to this market is investing in companies that derive revenue from China. Among U.S. businesses alone, we identified roughly 50 companies with Chinese revenue exposure of more than 30 percent and 100 with more than 20 percent exposure.
As China continues its rise as a leading economic player, there are many reasons for investors to look closely at opportunities there. As with any investment, though, the key is to be armed with as much information as possible.
Sr. Portfolio Manager Margé Karner sees attractive options for active managers headed into the second half of 2018, despite volatility.
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A-shares are shares of mainland China-based companies that are traded the Shanghai Stock Exchange and the Shenzhen Stock Exchange in local currency. The addition of these shares to MSCI's widely followed indexes is expected to spur billions of dollars in foreign investment in the Chinese market.
June 07, 2018
1 As of 3/31/18. Source: MSCI
2 June 2013. McKinsey and Company, "Mapping China's Middle Class ."
International investing involves special risks, such as political instability and currency fluctuations.
References to specific securities are for illustrative purposes only, and are not intended as recommendations to purchase or sell securities. Opinions and estimates offered constitute our judgment and, along with other portfolio data, are subject to change without notice.
The opinions expressed are those of American Century Investments (or the portfolio manager) and are no guarantee of the future performance of any American Century Investments' portfolio. This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.