Beat the big end of town to the Silk Road riches

Not unlike the Silk Road, the path leading to the inclusion of China A-shares in global indices has been a long and winding one. Index companies and Chinese authorities have been working together for many years to ensure the Chinese securities market is suitable for international investors.  Until recently investors outside of China have only been able to buy:

• H-Shares on the Hong-Kong exchange (the most common)
• N-Shares a small subset of Chinese shares on the New York Stock exchange
• S-Shares a small subset of Chinese shares on the Singapore exchange
• L-Shares a small subset of Chinese shares on the London Bourse, and
• B-Shares a subset of Chinese onshore shares that are traded in foreign currencies.

But it is A-shares that are the largest and most actively traded Chinese shares, traded almost exclusively by onshore domestic Chinese investors.  So big is the A-shares market that it ranks as the 2nd largest share market in the world by capitalisation, behind only NYSE.  The cross-border Stock Connect program which allows investors to buy A-shares via Hong Kong clearing houses is restricted by quotas which limits access for institutions that trade in large volumes.

To date, the limited access to A-shares for investors outside China has been the biggest obstacle for index providers including these securities in their global indices.  This is because index companies construct their indices to only include securities that are freely available otherwise institutional investors would and could not follow their indices. The institutional investor is not going to use an index that dooms them to failure when they can’t get hold of the underlying constituents.

The way institutional investors construct their portfolios is to hold positions similar to recognised indices. Otherwise they are taking a big risk. If markets go against them and they drastically underperform the index, they will be seen as incompetent. Better to be just above or just below the index.

Putting two and two together, the current difficulty of getting hold of China A-shares means that they are under-represented in institutional portfolios relative to the size of the Chinese economy because they are underrepresented in the indices. As China’s capital markets free up and their shares become more and more accessible, more index companies will add China A-Shares to their indices and will increase their weightings to China and by default the institutional investors will follow.

On 14 June index giant MSCI will announce its 2016 market classification results.  China A-shares are under consideration.  In April, MSCI released a consultation paper suggesting a 5% initial inclusion, which would equate to 1.1% of the MSCI Emerging Markets Index (or an estimated $16 billion).

MSCI has been working with Chinese authorities to overcome its capital, quota and ownership concerns.  On 31 March 2016, Bloomberg reported that the Chinese government has made significant steps to curb trading halts and clarify beneficial ownership rules.  These steps have addressed two of the five issues MSCI flagged in its consultation paper.  There are arguments for and against inclusion outlined in MSCI’s paper.  In summary these are:

Arguments for MSCI inclusion:

• As of 31 March 2016, China A-shares is the second largest equity market globally by exchange-listed market capitalisation (10% of global total) and the second largest by cash turnover (26% of total)
• There is a mismatch between the size of China’s economy and its representation in global indices.  China contributes 13% of global GDP, yet represents only 2.4% of the MSCI AC World Index
• In February 2016 the Renminbi Qualified Foreign Institutional Investor (RQFII) quota and application scheme was revised to improve market accessibility
• A-share inclusion would better represent China’s economy.  It is estimated that the number of Chinese based index constituents would increase from 153 to 574

We also note that FTSE has already launched a separate index for the inclusion of A-shares.

Arguments against MSCI inclusion

• There remains limits on the rate at which some investors can repatriate capital
• There are still concerns about the Chinese exchanges’ (Shanghai and Shenzhen) voluntary suspension rules which last year resulted in over 1,400 A-share companies being suspended at one time, and
• The current anti-competitive clauses which limit the investment and hedging vehicles available to international investors.

VanEck is one of few asset managers able to make A-shares available to its clients. VanEck has the only A-shares China ETF available on ASX through the stock code ‘CETF’.

CETF provides pure China A-share exposure, giving investors the opportunity to access the 300 largest and most liquid A-Shares without any repatriation restrictions. With CETF you can get in ahead of the big end of town which will follow when MSCI and other index providers include China A-Shares in their world indices.

If you would like more information on CETF please contact our ETF specialists on 02 8038 3300 or email us at info@vaneck.com.au

IMPORTANT NOTICE: Issued by VanEck Investments Limited ABN 22 146 596 116 AFSL 416755 (‘VanEck’). VanEck is a wholly owned subsidiary of Van Eck Associates Corporation based in New York, United States. VanEck Vectors ETF Trust ARBN 604 339 808 (the ‘Trust’) is the issuer of shares in the VanEck Vectors ChinaAMC CSI 300 ETF (Synthetic) ETF (‘US Fund’). The Trust and the US Fund are regulated by US laws which differ from Australian laws. Trading in the US Fund’s shares on ASX will be settled by CHESS Depositary Interests (‘CDIs’) which are also issued by the Trust. The Trust is organised in the State of Delaware, US. Liability of investors is limited. Van Eck Associates serves as the investment adviser to the US Fund. VanEck, on behalf of the Trust, is the authorised intermediary for the offering of CDIs over the US Fund’s shares and issuer in respect of the CDIs and corresponding Fund’s shares traded on ASX.

This is general information only and not financial advice. It does not take into account any person’s individual objectives, financial situation or needs. Investing in international markets has specific risks that are in addition to the typical risks associated with investing in the Australian market. These include currency/foreign exchange fluctuations, ASX trading time differences and changes in foreign regulatory and tax regulations.  Before making an investment decision in relation to the US Fund you should read the PDS and with the assistance of a financial adviser consider if it is appropriate for your circumstances. The PDS is available at www.vaneck.com.au or by calling 1300 68 38 37.

Past performance is not a reliable indicator of future performance. No member of the VanEck group of companies or the Trust gives any guarantee or assurance as to the repayment of capital, the payment of income, the performance or any particular rate of return from the US Fund.

The US Fund may gain exposure to the China A-Share market by directly investing in China A-shares and investing in swaps that are linked to the performance of China A-shares. An investment in the US Fund involves a significant degree of risk, including, but not limited to, the Adviser’s and Sub-Adviser’s ability to manage the US Fund, which depends upon the availability of China A-shares and the willingness of swap counterparties to engage in swaps linked to the performance of China A-shares. The US Fund may invest in swaps and derivatives that entail certain risks, including limited availability of swaps, counterparty risk, liquidity risk, risks of A-shares and the RQFII system, tax risk (including short-term capital gains and/or ordinary income) and currency risk. The US Fund may also invest in shares of other funds and absorb duplicate levels of fees with respect to these investments.

The US Fund is subject to elevated risks associated with investments in Chinese securities, including A-shares, which include, among others, political and economic instability, inflation, confiscatory taxation, nationalisation, and expropriation, market volatility, less reliable financial information, differences in accounting, auditing, and financial standards  and requirements,  and uncertainty  of implementation  of Chinese law. In addition, the US Fund is also subject to liquidity and valuation risks, currency risk, non-diversification risk, and other risks associated with foreign and emerging markets investments.