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China Gets Snubbed by Global Investors

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Thursday, June 11, 2015
Money and Markets
China Gets Snubbed by Global Investors
by Mike Burnick

Dear ,

Mike Burnick

Just two days ago, China got snubbed by MSCI Inc., the global giant in benchmark equity indexing, and for the second time in as many years.

But it's just a matter of time before this massive market is open for business to global investors and a tidal wave of investor capital flows into China.

Look, China's economy is already the world's second-largest and Chinese stocks listed on Mainland exchanges have a combined market cap of nearly $10 trillion. In the past year alone, Shanghai listed stocks have appreciated by $6.5 trillion, nearly the same as the entire value of Japan's stock market!

Global capital is set to rush into the Chinese markets.

So it won't be long before the floodgates are opened and global capital begins to pour into China. Here's the whole story ...

MSCI has been considering mainland Chinese A-shares, listed in Shanghai for inclusion in its popular emerging market index. It's a market-moving decision because global investors have $9.5 trillion in assets following MSCI indexes!

As part of its annual review process, MSCI consults with big institutional investors including global banks and fund managers to determine how to shape its index offerings. In 2014, MSCI passed over China's A-share market saying it was ineligible because of limitations to investing in Shanghai stocks.

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Since then Beijing has taken steps to open China's financial markets, including a stock connect program giving investors unprecedented access to China's mainland markets via the gateway Hong Kong Stock Exchange.

This year, MSCI's decision was a closer call, but in the end global investors felt like more open access was needed for A-shares. According to Bloomberg, five of 12 asset managers surveyed in May said China's A-shares should become part of the global indexes in 2015, but four said they shouldn't, and three were neutral.

In a statement Tuesday, MSCI again deferred inclusion of China's A-shares, but importantly, MSCI didn't deny them either.

In fact, the statement said that "MSCI and the China Securities Regulatory Commission (CSRC) will form a working group" and that it "expects to include China A-shares in its global benchmarks" as soon as "remaining issues related to market accessibility have been resolved."

One money manager interviewed by Bloomberg summed it up best: "Some might regard it as disappointing that it didn't happen immediately," but "it looks like it's going to happen anyway at some point. It's just a question of when."

In fact, odds are that MSCI will include China's A-shares well before next year's annual review process. When it happens, it won't trigger an immediate stampede of capital, because MSCI plans to move in stages.

First, about 5% of eligible A-shares would be added to the MSCI Emerging Market Index. That's worth about $2 billion in new money flows into Chinese stocks.

Longer term, however, it will be a watershed event for stocks listed in China, triggering $33 billon or more of inflows from index-tracking investors worldwide. And it's all bound to happen sooner rather than later because there's a strong competitive threat at work here.

MSCI's arch rival in the indexing business, FTSE Group, said last month it will launch two emerging market stock indexes that do include A-shares.

Plus index fund giant Vanguard Group, with $3.3 trillion in assets under management, is adding mainland Chinese stocks to its emerging market index funds.

So MSCI has every incentive to follow suit, or risk falling behind in the Chinese equity index land rush!

Bottom line: China's mainland stock market is rapidly opening up to investors, both institutions and individuals. One way to play it is with the Deutsche X-trackers Harvest CSI300 China A-Shares ETF (ASHR) which just opened for business itself in November 2014. Since then ASHR has surged 120.5% in value in anticipation of the A-share inclusion.

But as I pointed out previously, the rally in mainland stocks has widened the premium of A-shares over Hong Kong-listed H-shares to 36 percent, the most since 2011!

That's why the best way to tap into China's booming stock market at a discount is by considering ETFs that invest in Chinese stocks listed in Hong Kong; they offer a more attractive valuation.

For example, the iShares China Large Cap ETF (FXI) is a much better bet in my view, with a price-earnings (P/E) ratio of just 11.8 compared to ASHR P/E of nearly 17. And FXI looks like a bargain on other valuation measures too, including Price-to-book (P/B) with a value of just 1.5 versus 2.4 for ASHR.

Either way, a global tsunami of index-tracking money flows are bound for China's stock market going forward, so be sure you're ready to take full advantage.

Good investing,

Mike Burnick

The investment strategy and opinions expressed in this article are those of the author's and do not necessarily reflect those of any other editor at Weiss Research or the company as a whole.

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