China A-Shares: Include Them In Your Portfolio Now
- As from next month, Chinese A-shares will be included in the MSCI Emerging Markets Index.
- The Chinese economy isn’t running too hot or too cold.
- Chinese A-shares have currently a low correlation with developed and emerging markets.
- The valuation of Chinese A-shares is cheap and momentum is positive.
The inclusion of China-A shares into the MSCI Emerging Markets Index will be a long-term process and hence a driving force for Chinese A-shares in the years to come. The valuation of A-shares is cheap, although they are more expensive than H-shares.
A-shares vs H-shares
The Chinese stock market is relatively young and started in 1990 with the establishment of two mainland exchanges: the Shanghai Stock Exchange and Shenzhen Stock Exchange. The main boards of the Shanghai and Shenzhen Stock Exchanges list larger and more mature stocks, like the NYSE in the US.
Stocks of Chinese companies traded on the Shanghai Stock Exchange and the Shenzhen Stock Exchange are called A-shares.
H-shares are listed on the Hong Kong Stock Exchange; they are available mainly to non-Chinese investors. But in both cases, the origin of business should be mainland China.
Historically, A-Shares were accessible only to domestic investors or foreign institutional investors through the Qualified Foreign Institutional Investor (QFII) system. But with the launch of the Shanghai-Hong Kong Stock Connect in November 2014 and the Shenzhen-Hong Kong Stock Connect in December 2016, that changed.
The Stock Connect allows foreigners to trade certain Chinese stocks listed on the Shanghai and Shenzhen exchanges and for Chinese investors to trade shares in Hong Kong. The program includes more than 2,000 China A-shares that can be traded by investors through the Hong Kong Exchange.
Now the restrictions on foreign investors are easing and investors willing to accept the risks associated with investing in China can access the growth-potential of one of the world's fastest-growing economies with Deutsche X-trackers Harvest CSI 300 China A-Shares ETF (NYSEARCA:ASHR). This was the first exchange traded fund to offer U.S. investors direct access to the China A-shares universe. The ETF seeks investment results that correspond generally to the performance of the China Securities 300 Index (CSI 300 Index).
MSCI Emerging Markets Index Inclusion
Global market index provider MSCI last year announced that it would start including China's A-shares into its MSCI Emerging Markets Index as from June of this year. MSCI is the world's most important index provider. Its decisions affect trillions of dollars of trading in the stock market.
Despite all the enthusiasm in the financial media surrounding the news, it's important to remember that the A-shares that MSCI is including in its MSCI Emerging Markets Index thus far only represent a tiny fraction of that index.
MSCI adjusts its inclusion in the index to reflect not just market capitalization of stocks, but free float available to investors, as well as foreign ownership limits on shares in companies and access to market for investors. In total, Chinese shares will represent about 29.28% of this index by August 2018. But that 28.55% is represented by stocks of Chinese companies trading on exchanges outside of China itself. Only about 0.73% of the total index will be Chinese A-shares.
China's weight in global benchmarks-and thus its relevance to investors-will increase materially over the next decade. Initially, when MSCI adds China A-shares to its indices in June 2018, it will use a 5% inclusion factor and include only 222 large-cap companies. As MSCI increases its inclusion rate, China A-Shares could reach nearly 10% of the index. At full inclusion of more than 3,500 companies, China A-Shares could represent more than 15% of the MSCI Emerging Markets Index.
But that is likely far in the future. Reaching full inclusion takes a great deal of time. To provide some historical context about how fast China's weight in global benchmarks could increase, consider Taiwan and South Korea. Taiwanese equities took nine years (from 1996 to 2005) to achieve full inclusion, and South Korean equities took six (from 1992 to 1998). China is starting with a much lower inclusion factor of 5% (versus 20% for South Korea and 50% for Taiwan), so I believe it could take at least a decade for full inclusion to be achieved.
The Chinese economy
The Chinese economy isn't running too hot nor too cold. The shadow banking problem is tackled and China's effort to rebalance its economy toward consumer-led growth is running according to plans.
According to the OECD, GDP growth is projected to remain strong. Industrial production growth has been picking up and profits have improved on the back of higher producer prices. The share of processing trade is declining but demand for services, in particular on account of tourism and foreign intellectual property, will remain high.
The monetary policy stance will continue to be neutral with a tightening bias even though selective easing will be implemented to improve access by small businesses and agriculture to credit.
Exhibit 1: Chinese economic growth
Also in the real estate sector the market is cooling down to more acceptable inflation levels.
Exhibit 2: Chinese real estate prices
Fiscal policy will remain supportive with the launch of multiple large-scale infrastructure projects.
Shadow banking is being reined in, but bank lending continues to grow. Corporate debt has stabilized relative to GDP at a high level but household debt is rising, though from a very low base.
Exhibit 3: Chinese debt figures
These debt loads are worrisome for China. But, since China's debt is domestic, not owed to foreigners, and not denominated in other currencies such as the U.S. dollar or the euro, China probably has the tools to manage this challenge.
Li Keqiang, the Premier of the People's Republic of China described a decade ago to a U.S. diplomat the official GDP-figures as "man-made". This inspired The Economist to create an index of his three preferred measures of economic growth in China that now bears his name: the Li Keqiang index.
The index, which comprises the annual growth rate of outstanding bank loans (40%), electricity consumption (40%) and rail freight (20%), shows a significantly more volatile trajectory for China's growth than the official GDP.
By the measure, China's 2015 slowdown was much worse than the official GDP indicates, and the subsequent rebound much bigger. That the index is volatile should not be surprising as it narrowly focuses on just three sectors, would show more variability than a broader measure such as GDP.
Exhibit 4: Li Keqiang index
Both the Caixin China General Manufacturing PMI and the Caixin China General Services PMI are above 50, confirming the positive backdrop we described the Chinese economy experiences. The Chinese economy is growing strongly.
Exhibit 5: Caixin China General Manufacturing PMI
Exhibit 6: Caixin China General Services PMI
And we expect this growth to continue. China is expected to account for more than one third of total global growth in 2018, according to KKR.
Exhibit 7: 2018 Real Global GDP-growth
Deutsche X-trackers Harvest CSI 300 China A-Shares ETF is quite heavily exposed to Financials. The second and third place are for Industrials and Consumer Discretionary.
Exhibit 8: Deutsche X-trackers Harvest CSI 300 China A-Shares ETF sector allocation
The weight in the technology-sector is rather low, but given the high valuation and the poor recent performance of the giant Chinese tech stocks, we consider this as a positive.
Exhibit 9: Chinese tech stocks poor performance
The AH premium
Companies with both a listing in Hong Kong (H-shares) and in Shanghai or Shenzhen (A-shares) show a very remarkable price divergence. The A-shares tend to trade at a premium. There is even an index created that tracks this price difference. The Hang Seng Stock Connect China AH Premium Index tracks the average price difference of A-shares over H-shares for the most liquid Chinese companies with both A-share and H-share listings.
Exhibit 10: Hang Seng Stock Connect China AH Premium Index
The index takes the value 100 in case A-shares and H-shares are valued the same. Currently the A-shares are 20% more expensive.
This premium is a bit of a puzzle. With the greater openness of the Chinese stock markets, one would expect this premium to be arbitraged away. Apparently there are limits to the arbitrage. Profiting from that gap has proven difficult in the past. Valuation differences were expected to narrow after the Shanghai-Hong Kong exchange link opened in 2014, but they grew instead. Still, since China's stock boom turned to bust in the middle of 2015, the price differential between the markets has become less extreme.
The stocks are non-fungible. While the same shares are available on both exchanges, their trading environments are clearly not the same.
Richard Gao, research principal at Matthews Asia, a San Francisco-based asset manager, notes that the premiums tend to be highest when there is a bull market in both mainland and Hong Kong equities. He attributes this to the momentum-driven investment style favored by many Chinese retail investors. It may simply be that investors in A-shares feel that this is where the biggest gains are to be made.
Yet even those in search of discounts face some barriers. One such is that Stock Connect is only open to those with investable assets of at least Rmb500,000 ($77,000). This rules out many retail investors, who dominate trading in A-shares.
On an individual stock-level, the differences in premiums are huge and range from -7% to 173%! Six of the top 10 holdings in Deutsche X-trackers Harvest CSI 300 China A-Shares ETF have a dual listing. Ping An's premium is only 2.4%. Exhibit 11 shows the premiums for the other top10-holdings.
Exhibit 11: AH-premium
There is an ETF that systematically replaces A-shares that trade at a premium with their cheaper H-counterparts. The ticker is (I'm not joking) HAHA. CSOP China CSI 300 A-H Dynamic ETF (HAHA) is based on the same index (CSI 300) as Deutsche X-trackers Harvest CSI 300 China A-Shares ETF, but tracks the so-called CSI 300 Smart Index. For value-conscious investors this could be a logical alternative to the Deutsche X-trackers Harvest CSI 300 China A-Shares ETF. Unfortunately the CSOP China CSI 300 A-H Dynamic ETF is very small, with only $1.6 million in AUM.
The Deutsche X-trackers Harvest CSI 300 China A-Shares ETF has a much cheaper valuation compared to the iShares Core S&P 500 ETF (IVV). We expect that Chinese A-shares will get a valuation more in line with the MSCI All Countries Index in the coming years.
Exhibit 12: Valuation
Broadly speaking, emerging markets have become increasingly correlated to other global asset classes. But China A-Shares tend to have limited correlation to other emerging and developed markets.
Exhibit 13: China A-shares correlation
This obviously creates nice diversification benefits.
On the graph of the Deutsche X-trackers Harvest CSI 300 China A-Shares ETF we can clearly see that the momentum is positive.
Exhibit 14: Price chart Deutsche X-trackers Harvest CSI 300 China A-Shares ETF
The combination of...
- strong economic growth,
- the positive impact of the MSCI Emerging Markets Index Inclusion,
- diversification benefits,
- areasonable valuation, and
- positive price and earnings momentum
... should reward investors: BUY Deutsche X-trackers Harvest CSI 300 China A-Shares ETF!
Performance earlier recommendations
In exhibit 15 you can see the returns of the earlier country-ETF recommendations made by The Belgian Dentist, both in absolute terms and relative to the performance of iShares MSCI ACWI ETF (NYSEARCA: ACWI).
So far, so good!
Exhibit 15: Performance earlier recommendations
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Analyst’s 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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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