We don't often make big buy recommendations on China. Until this year, we'd only ever recommended a broad buy on Chinese stocks once before. (We've recommended individual stocks many times, but I'm talking about a market-wide buy recommendation).
But in May, we made a big call on Chinese stocks.
As we said, global investors simply can't afford to ignore mainland China anymore. This is a market we should all be exposed to…
Why investors have stayed out of Chinese stocks
China's mainland equity market is a strange beast.
For decades, China's equity market has been a tightly closed ecosystem, with foreigners only allowed to participate through strict quotas under various Qualified Foreign Institutional Investor ("QFII") programs.
That means the market is almost entirely driven by local investors - and retail investors in particular (around 80 percent of the market).
So China's mainland equity market is largely driven by internal events. What happens in the U.S. and European markets are of relatively little importance.
And retail investors are much less fundamentally driven in their stock selection. Classic equity market fundamentals like a company's earnings and balance sheet are less important than domestic news, rumor and speculation.
This had made China's market volatile. There have been huge, rapid bull markets followed by swift corrections.
Policy intervention also happens frequently in Chinese markets. China's government culture is riven to the core with a deep and constant propensity to tweak, direct and otherwise control most aspects of economic life. So the stock market is viewed as a policy tool of economic growth, finance, social policy and political influence.
Investors don't like seeing a stock market "micromanaged". So this is a big reason why most investors have stayed away.
Why buy now?
1. MSCI Index inclusion.
In short, MSCI is the world's most important index provider. Its decisions affect trillions of dollars of trading in the stock market. Fund managers and investors use its indices as a benchmark to build emerging-market portfolios.
Since its June decision to include Chinese A-shares in its indices, MSCI has added 222 A-share large-cap stocks into its MSCI Emerging Markets Index. That accounts for 0.73 percent of this flagship index.
Now, this won't cause a tidal surge of capital to flow into Chinese equities right away. But it's a strong positive for China's ongoing integration in global equity market portfolios.
2. China is globally underweight, BUT access is getting better.
China's mainland stock markets combined make China the second-largest market in the world. Yet, as you can see in the following chart, China's weight in global emerging market funds relative to its weight in MSCI's Emerging Markets Index is at record lows.
In other words, global emerging market fund managers have allocated less to China than the basic MSCI benchmark suggests they should.
We think these funds will soon increase their allocation, especially as their ability to access mainland Chinese equity markets gets better.
As I said earlier, China's equity market has traditionally been a tightly closed ecosystem, with foreigners only allowed to participate through strict quotas under various Qualified Foreign Institutional Investor programs.
However, over the past couple of years, we've seen overseas access expand through the creation of various "through trains" like the Shanghai-Hong Kong Connect and Shenzhen-Hong Kong connect. These trading platforms allow investors to buy mainland Chinese "A-shares" via Hong Kong. So the market is slowing beginning to open up to foreign investors.
3. Domestic pension funds.
Pension funds all over the world are a huge source of capital for equity markets. These companies hold massive amounts of cash that must be managed, and a sizable proportion of that cash usually finds its way into equities, along with other asset classes like fixed income and real estate.
As recently as 2015, Chinese pension funds weren't allowed to buy stocks in the local equity market.
But over the past few years, pension funds have gradually been allowed to increase their asset allocations into domestic equities.
We think this trend will continue.
Again, we don't expect this to drive a massive influx of money into the A-share market all at once. It will be more gradual. But the key is that pension funds represent more stable capital rather than retail speculative day trading. This will hopefully help the market mature and ultimately shift emphasis towards equity fundamentals (i.e. traditional valuation metrics).
4. Regulatory maturity.
China's stock market regulators have a reputation for being heavy-handed in response to large swings in the domestic equity market.
The reality is that, because of the large retail participation in Chinese stocks, regulators want to move away from speculative bubbles and busts, to a more mature and developed market, which relies more on fundamental valuation and research instead of hype and speculation. Having retail investors wiped out in speculative crashes does not promote the kind of "social harmony" that remains a core objective of the Chinese Communist Party.
In recent months for example, China's main regulatory body, the China Securities Regulatory ("CSRC"), has vocally pledged to crack down on speculative trading, especially in smaller-cap stocks.
Chinese authorities are taking steps to encourage stable development of its capital markets. That means things like reducing leverage in the financial system. This is healthy for us as investors. We don't want to be subject to the kind of wild swings that have characterized previous booms and busts.
These are just a few of the reasons why we're making a big bet on China today. The simple fact is, the size and growing role of China's equity market makes it impossible to ignore.
How to buy China
The easiest way to invest in China is through and exchange-traded fund like the KraneShares Bosera MSCI China A ETF (NYSEARCA:KBA). KBA tracks the MSCI China A International Index, which tracks the equity market performance of large-cap and mid-cap Chinese securities listed on the Shanghai and Shenzhen Stock Exchanges.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.