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Investors: pay heed to China (and India)

The opportunities outweigh their weighting in global indices.

Using a simple show of hands, investors and fund managers at the recent Schroders Investment Symposium in Cape Town were asked to indicate whether they were invested in China and India, and if so, whether it was via an index tracking fund or an actively managed fund. 

These are the second and sixth largest economies in the world, so it was not surprising that many attendees are invested in these economies, but almost universally, people were invested via an index fund, like the MSCI Emerging Market (EM) Index.

Up until now, the safety of a diversified index was perhaps not a bad plan. After all, Chinese markets, as depicted by MSCI China A in the graph below, have underperformed relative to both the MSCI and EM indices.

Source: Schroders

However, things are changing, says Gavin Ralston, head of official institutions at Schroders Investment Management, and investors should be alert to the opportunities. In fact, when it comes to fast-growing economies like China and India, he suggests that an active investment strategy may, at this point, deliver greater returns than a generic index tracking strategy. 

Focusing on China, he points out that the indices have limitations. For one, even though China has a 31% weight in the EM index, the investible universe is very narrow. “By ignoring the broader market, investors are missing out on smaller, fast-growing companies,” says Ralston.

That’s because the MSCI China Index, the sub-index of the MSCI Emerging Market Index, is made up of Chinese stocks listed in Hong Kong and American Depositary Receipts, which are Chinese stocks listed in the US. Yet the MSCI China Index, with its 459 constituents and $1.6 trillion market capitalisation, is only about 16% of the $10 trillion China equity universe.

China slowly relaxing the rules

However, restrictions on investing in Chinese stocks are starting to change. The Chinese government is slowly relaxing the rules that prevented foreign investment in mainland stocks listed in Shanghai or Shenzhen, typically known as A-shares. The total market capitalisation of A-shares is almost $7 trillion, making it the third largest stock market in the world after the New York Stock Exchange and the Nasdaq.

Index providers have taken notice of this liberalisation. In 2018, MSCI announced that it would add China A-shares to its suite of global benchmark indices. It is doing so in a step-by-step fashion. So, as of February 2019, 5% of eligible large-cap A-shares was included in the indices. The 5% inclusion factor will increase to 20% over the course of 2019. MSCI is also considering including A-shares of mid-cap companies under the same terms as large-cap A-shares, as well as stocks listed on the technology-focused ChiNext market.

But considering the performance of China A-shares, why should anyone rush to invest in them – whether via an index or otherwise?

An investor’s decision to invest in emerging markets is usually based on the belief that faster economic growth in these countries will lead to higher investment returns, says Ralston. But the reality is not as straightforward. For one, an emerging market is not the same as an emerging economy. Several countries that feature in MSCI’s emerging market indices could be classified as advanced economies. South Korea and Taiwan are two examples. That’s because the IMF ranks countries based purely on economic criteria, while index inclusion is governed by considerations about market size, liquidity and accessibility as well as economic status or prospects.

No two countries are alike

Investors should also be aware that within the index no two countries are alike. Just consider the difference in annual per capita income between Pakistan ($1 548) and Qatar ($63.506), where per capita income is higher than the US. Obviously, Pakistan and Qatar have little in common. “This illustrates how different emerging markets are at different stages of development and are not all on the same development path,” says Ralston.

However, ignoring the fact that they are very different countries and markets, investors assume that what all EMs have in common is the ability to catch up with developed markets.

But Ralston argues this is also not strictly true.

In 1960, seven EM countries had a GDP per capita of less than 20% of the US. Since then, only the Japanese and South Korean economies have converged with developed markets, moving closer to, or in the case of Japan at times exceeding, the living standard of the US. 

However, China has been a rare success story, going from 2% of the US GDP per capita in the early 1990s to 15% in 2017. Looking forward, the growth is expected to continue and China’s economy will move closer to a developed economy, says Ralston.

GDP vs earnings growth

Another hurdle with EM investments is that the link between GDP and earnings growth is tenuous. As a result, buoyant economic growth in some emerging markets might not translate into equally fast earnings per share (EPS) growth. And the latter is ultimately what matters for investors.

Some may argue that transparent reporting is not a feature of many Chinese companies and that in the past it was difficult to differentiate between good private companies and debt-laden state-owned enterprises. “These are valid concerns, but this is also changing and the opportunity to weed out the bad is considerable,” he says. “That is why active managers have a window in which they can outperform the market.” 

The point Ralston is making is that the EM investment universe is constantly shifting, and that investing in emerging market equities requires a hands-on approach that is more flexible and dynamic than the EM indices can achieve. “An approach that is heavily influenced by index construction carries the risk of allocating too much to countries with declining importance and, by implication, too little to countries with increasing importance,” he says.

The chart below demonstrates this clearly.

China’s share in the global economy and stock market

Source: Schroders

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Before you do any investing in/with China, please watch THE CHINA HUSTLE first on Netflix.

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