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All Aboard the Through Train

China A-Shares

What is the current investable universe?One of the dominant investment themes in recent history has been the growth of China. China’s rise from being one of the world’s poorest countries in 1978, the year which China began to liberalise its economy, to the second largest economy in the world, is unrivalled.

The chart below shows the extent of growth in China, measured by gross domestic product (GDP) and gross national income (GNI).

Chinese economy growth

— GDP (LHS) — GNI per capita (RHS)

In tandem with national growth, investment returns on Chinese equity indices have also been strong, with the MSCI China Index returning over 15% per annum over the last decade through to March 2015.

Foreign investors attempting to access this growth in China are able to invest in a number of different Chinese equity shares. These include China H-Shares1, China B-Shares2, China Red Chips3, China P-Shares4 and China securities listed in New York and Singapore. Despite the confusing number of equity investments that are available to foreign investors, a substantial part of the market, domestic A-Shares, have largely been inaccessible to them. Foreign investors who have wanted to purchase A-Shares were restricted by a tightly controlled licensing framework.

Non A-Share classes are skewed toward certain parts of the market such as State Owned Enterprises and banks, and limit how investors can capitalise on Chinese economic growth. The consumer sectors, which we believe to be a desirable investment proposition (see forthcoming Aon Hewitt publication Actively Emerging Equity), are less represented. Sectors such as Consumer Staples, Consumer Discretionary and Healthcare represent around 10% of the MSCI China Index. The Index is also concentrated, with the top 10 stocks representing 50% of its market capitalisation.

This paper examines the improving access that international investors are gaining to equity investment in China. Access to the domestic “A-Share” equity market has recently improved as the Chinese authorities have allowed investment in these shares through the “Shanghai-Hong Kong Stock Connect” scheme, otherwise known as the “through-train”.

This development is very significant for the following reasons:

• The A-Share market provides an improved representation of the China opportunity set, with better access to domestic consumption.

• A-Shares will probably be included into mainstream equity indices. Full inclusion would see China’s weight increase to as much as one third of the entire MSCI Emerging Market Index.

• Alpha opportunities for active managers in this market should be enhanced.

In a wider context, these changes represent one of many investment opportunities available to Emerging Market investors, which are further explored in associated Aon Hewitt publications such as The World is Not Enough (2013) and the forthcoming Actively Emerging Equity (2015).

We believe that clients should be aware of these developments and engage with their managers and custodians to make sure that they are prepared to benefit from the new, and likely further improving, access to these shares.

All Aboard the Through Train China A-Shares

GD

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GNI per capita. Source: World Bank, International Comparison Program database. http://databank.worldbank.org/data/views/reports/tableview.aspxGDP: World Bank national accounts data, and OECD National Accounts data files. http://databank.worldbank.org/data/views/reports/tableview.aspx

What is the China A-Share market?Chinese A-shares are Renminbi-denominated stocks that trade on the Shanghai and Shenzhen stock exchanges. Until recently only certain classes of foreign investor, so called Qualified Investors, could access A-Shares after a long application process, and access was limited to small quotas — this was the Qualified Foreign Institutional Investors (“QFII”) scheme. The quota process came with restrictions such as lock-ups, remittances, less frequent dealing and repatriation limits.

Despite the difficulty in accessing them, domestic Chinese stock exchanges are extensive in size. As of December 2014, measured by market capitalization5, the Shanghai Stock Exchange was the fourth largest in the world ($3.9 trillion) and the Shenzhen Stock Exchange was the 8th largest ($2.1 trillion). Being able to fully access these A-Share markets would add a further 2,000 companies for foreign investors to invest in, and represent 40% by capitalisation of their enlarged China opportunity set. Whilst some of the A-Share companies have dual listings6 and are readily available for foreign investors, the overwhelming majority are unique listings in mainland China.

The range of A-Share companies is more diversified than the MSCI China Index opportunity set. The A-Share Index has twice the amount of Consumer related stocks than the MSCI China Index. The top 10 stocks also represent just 18% of the A-Share Index. A-Shares provide access to a number of Chinese industries that are not represented in other China share classes, providing more potential exposure to domestic consumption and technology. The size of the middle class in the emerging world is expanding rapidly, and this is only set to continue, making access to these Chinese companies an important investment opportunity. The chart below shows a number of Chinese industries that are accessible only through A-Shares7.

The graphs below show the sector distribution of the current MSCI China Index and the mix of share classes that the Index currently contains.

MSCI China sector weights MSCI China share classes

Health Care2%

Materials2%Utilities

4%Consumer Staples

4%Consumer

Discretionary5%

Industrials7%

Energy10%

TelecommunicationServices

12%Information Technology14%

Financials40%

B-Shares1%

P-Shares20%

Red Chips27%

H-Shares53%

Source: MSCIhttps://www.msci.com/resources/factsheets/index_fact_sheet/msci-china-index.pdfhttps://www.msci.com/resources/factsheets/index_fact_sheet/msci-china-a.pdf

Historically, the A-Share market has been less efficient, partly due to limits on foreign investment. By limiting foreign investment, a large proportion of the A-Share market trading is performed by non-professional local individuals8 (who in turn have been restricted from investing outside of their domestic markets). Local investors have been widely credited for creating volatility through sentiment and speculative investment and have created price distortions when compared to similar shares listed on international markets.

Though risk of slowing growth in China needs to be considered (please refer to Aon Hewitt Asset Allocations views, China Concern 2014), the absolute increase in GDP last year was twice the amount ten years ago when the rate of growth was higher, because of the increased base. There will be selective companies likely to benefit from this absolute growth in the expanded opportunity set that are suitable for active Emerging Market managers. Many A-Share companies are sufficiently liquid, and at least initially, will have fewer analysts researching them. We believe this means that there will be opportunities to add value by actively selecting stocks.

How does the Shanghai-Hong Kong Stock Connect “through train” work?The Chinese authorities have recently taken significant steps toward improving access to A-Shares for foreign investors. Running parallel to the quota system, investors were given an alternative way to access the A-share market.

The Shanghai-Hong Kong Stock Connect programme or “through train” was launched on 17 November 2014 to create mutual market access between the stock exchanges of both Shanghai and Hong Kong. This trading link is open to all Hong Kong and overseas investors eligible to trade on the Hong Kong Exchange. In addition to foreign investors purchasing A-Shares ‘northbound’, mainland China investors may also now invest ‘southbound’ in some Hong Kong listed shares.

By trading through the Hong Kong Exchange, investors will benefit from the Hong Kong Exchange’s rules of law and business transparency, and will not need to go through the former licensing process to purchase A-Shares. By combining the Hong Kong stock exchange, with eligible A-Share investments in Shanghai, the “through train” theoretically creates the second largest exchange in the world, behind only the New York Stock Exchange.

At the moment, this is a pilot program and is limited to around 550 stocks listed on the Shanghai Stock Exchange, accounting for 90% of its capitalisation. For companies that are included on the “through train” there are also quotas in place specifying maximum net daily trading volume and overall aggregate trading quotas. However, compared with the existing QFII scheme, it should allow quicker access and more flexible holding periods.

Industries in China unique to A-Shares

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Inclusion into indicesThough the A-Share market meets MSCI criteria such as size and liquidity, full inclusion of A-Shares into mainstream indices has not happened to date, primarily because of limitations to foreign ownership resultant from the quota process. However, the opening of the “through train” adds momentum to the likelihood of gradual A-Share inclusion into the broader MSCI series.

MSCI’s latest review is underway with an announcement on possible inclusion of A-Shares expected at any time now. However, we expect any allocation to be on a limited basis and implemented over a period of time.

If A-Shares had been fully included in MSCI Indices at the last index review (June 2014), they would have represented around 40% of the MSCI China Index and increased the China weight in the MSCI Emerging Markets Index to around 30%9. To put this in context, A-Shares alone could represent 10% of the MSCI Emerging Markets Index, greater in weight than each of the other original “BRICs”, Brazil, Russia and India. Inclusion of A-Shares will further skew an already Asia heavy benchmark, something passive Emerging Market investors should keep in mind as countries graduate in and out of indices.

China22%

Asia ex-China(primarily Korea,

Taiwan and India)45%

EasternEurope10%

Africa / Middle East10%

Latin America17%

China30%

Asia ex-China (primarily Korea, Taiwan and India)

40%

EasternEurope7%

Africa /Middle East9%

Latin America15%

Current MSCI emerging markets MSCI China share classes

The programme does not include the material Shenzhen stock exchange. This is important because the Shenzhen exchange has a higher proportion of privately held mid-capitalisation names and fewer large cap state owned companies, which will be appealing to overseas investors. Access to the Shenzhen Exchange listed companies though a “Shenzhen-Connect” is widely acknowledged to be in the pipeline, expected later this year.

The “through train” programme is in its infancy, so does come with some uncertainty, which has limited its uptake to date. The primary issue is elevated counterparty risk due to an extended settlement period when selling A-Shares. A question mark over long term tax arrangements also remains. That all said, given the clear intention of the Chinese authorities to liberalise and open its economy, we would expect these issues to be addressed over time.

Source: UBS, MSCI

How are managers reacting to these developments?Despite improved access to A-Shares, and some managers increasing research efforts in the A-Share market, we have not observed institutional managers making significant allocations to A-Shares. Though some have made allocations to client benefit, many are operating a cautious “wait and see” approach due to the operational issues noted above.

Anecdotally, where we have seen manager activity in A-Shares has been in capturing arbitrage opportunities in dual listed shares, rather than investing in the long tail of unique listed companies in China. We believe that this continues to offer a less tapped opportunity for active management.

We believe the A-Share market improves both the opportunity set and improves the alpha potential for China equity investment, and believe managers should be preparing to take advantage of these developments.

Given the nuances of China A-Shares, and the fact that governance and transparency lag developed markets, we would recommend utilising only a suitably skilled and appropriate Emerging Market manager to access China A-Shares who can manage these risks.

1 A Chinese company incorporated in mainland China, but listed on the Hong Kong Stock Exchange (or a foreign exchange).2 A Chinese company incorporated in mainland China, that trade on the Shanghai or Shenzhen stock exchanges which foreign investors can purchase. 3 A Chinese company incorporated outside of mainland China (normally in Hong Kong) and listed on the Hong Kong Stock Exchange. These shares are typically State Owned Enterprises.4 A Chinese company incorporated outside of mainland China and Hong Kong (e.g. Cayman Islands), but which trades on the Hong Kong Stock Exchange.5 Source World Federation of Stock Exchanges.6 A company listed on two separate stock exchanges. For example a company listed in Hong Kong and mainland China.7 Source: Prescient Investment Management, Goldman Sachs, Wind, Factset.8 Around 80% of the A share market trading is by retail investors. Source: Investec.9 Source UBS, MSCI.

What are the effects on Chinese share returns?The Shanghai-Hong Kong Stock Connect program was initially announced in April 2014, and between then and its launch in November 2014, domestic Chinese markets have rallied (reasons include increased retail activity and looser economic policy). Following its launch, trading volumes in A-Shares picked up significantly, though have since reduced, and the daily capacity of the northbound “through train” has not been tested since its first day of trading.

Longer term, increased scrutiny from international investors in China should increase governance standards, transparency and eventual market efficiency. These improvements should fundamentally improve A-Share attractions and boost valuations.

Index inclusion will likely spur technical share price increases as significant inflows of capital could be expected from managers, most notably Index tracking managers. Such an effect was most recently evidenced by Qatar’s graduation from the MSCI Frontier Index to the MSCI Emerging Market Index in May 2014, with the country Index moving upward over 30% in the months preceding this, and 5% on its last day before the move.

There has been clear evidence that some investors have already benefitted from the new access to A-Shares as valuation discounts between dual listed A and H-Shares have ebbed and flowed, as investors attempt to take advantage of arbitrage opportunities. Most recently, Hong Kong H-Shares have rallied strongly as local China mainland investors have heavily invested southbound.

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About Aon Hewitt

Meet the expertConclusionDespite a relatively slow initial uptake, we expect A-shares to increasingly feature in investor portfolios and also to gain a fillip through eventual inclusion in market indices. We would anticipate a potential early mover advantage for managers.

We would encourage clients to be aware of these changes and be engaged with their managers and custodians, to ensure they stand to benefit from the opportunity, as operational issues in the scheme are addressed.

These developments in the China equity market underline the longer term benefits of an allocation to Emerging Market Equity. We therefore encourage investors with small allocations to Emerging Market Equity to build up their equity exposure.

James joined Aon in 2011 and works as Equity Researcher in Global Investment Management team at Aon Hewitt. He is based in the UK.

James is responsible for manager research across the full spectrum of equity asset classes with particular current focus on Emerging Market strategies. His experience includes research of Global Equity, Emerging Markets, Frontier and regional equity strategies.

james.jackson@aonhewitt.com +44 (0)207 0869 453

James JacksonConsultantAon Hewitt Global Investment Practice

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