LCP clarity:
‘Emerging markets’ is an outdated term that understates the economic importance of these regions.
LCP insight:
Take a fresh look at your equity portfolio and consider your allocation to emerging markets, including China A-shares.
Emerging markets are home to over 80% of the world’s population and contribute to a third of global GDP, but typically occupy just a small allocation, if anything, in investors’ portfolios. Is this justified?
First coined by World Bank economist Antoine Van Agtmael, the concept of emerging markets has existed for 40 years but is an outdated construct. Countries labelled as ‘emerging’ have not, in practice, just ‘emerged’ over recent years, but in some areas may have achieved elements of development in excess of what we know as developed markets. So, the picture is complicated, as emerging markets are highly heterogeneous.
Today, the vast majority of the world’s high-tech chip manufacturing capability, crucial to almost every part of the modern economy, is listed in emerging markets. The east coast of China boasts a dynamic tech hub and ecosystem that’s comparable to Silicon Valley, and if you look at unicorns (privately held start-ups value above $1bn) you will find that China is home to more than any other country excluding the US.
Do we need to give emerging markets a rethink?
China’s importance on the global stage is significant. China has the world’s largest population – 1.4 billion. China’s economy is the world’s second-largest (as measured by nominal GDP). Since China began to open up and reform its economy in 1978, GDP growth has averaged almost 10% a year, making it one of the fastest-growing major economies. Notably, it was the only major economy to report growth in 2020 as strict virus containment and business support measures assisted its recovery.
Despite its size and economic importance, China is underrepresented in global capital market indices. Though China contributed more than 18% to global GDP over 2020, it comprises only around 5% of the MSCI All Country World Index. Consigning such a vast economy to the status of ‘emerging markets’ seems overly simplistic. The BlackRock Research Institute recently announced that it would be separating Chinese assets, ie debt and equity, from emerging markets as distinct tactical allocations. We encourage investors to review their equity portfolios holistically to ensure they are aware of the opportunities available within the asset class, including emerging markets, and are able to take advantage of these.
The Chinese equity market includes some of the largest and most dynamic technology companies globally, including Tencent and ByteDance (which owns a company you may have heard of: Tiktok) as well as e-commerce giants like Alibaba. Some of these firms employ business models and products not seen in the developed world, for example, the group buying and social shopping model of Pinduoduo, whereby the more users that participate in the purchase, the lower the price of the item goes, thus encouraging users to share products on their network.
“China contributed more than 18% to global GDP over 2020”
Madeline Chelper
Guest author
What are China A-shares?
China A-shares are the equity shares of China-based companies that trade on the Shanghai and Shenzhen Stock Exchanges and are denominated in RMB. The Chinese equity market is comprised of several share classes, which differ by listing, currency and country of incorporation. H-shares, for example, are issued by China-based companies that trade on the Hong Kong Stock Exchange and are denominated in HKD.
Why focus on A-shares?
The A-share market is comprised of over 3,500 stocks, has a market capitalisation of over $8 trillion and is the largest component of the Chinese equity market. Given its scale, the A-share market offers investors a broad set of investment opportunities, including diversification benefits against developed market equities. This is attributable, in part, to the domestic nature of the market, which until recently, has been largely inaccessible to foreign investors. The A-share market is fairly diversified by sector, with Financials, Consumer Staples, and Industrials comprising the three largest sector exposures.
Source: MSCI Indexes: MSCI ACWI; Investing in China; MSCI Developed Markets. https://www.msci.com/our-solutions/indexes Certain information ©2021 MSCI ESG Research LLC. Reproduced by permission.
MSCI and JP Morgan now include A-shares in their emerging market indices (globally accessible to investors), however foreign investment in the A-share market remains low at around 7%. As index providers continue to increase their allocation to A-shares, passive fund flows will drive up the value of this asset class.
For passive investors, exposure to the A-share market has been led by index providers, however, this may not be the best approach. Investors should consider whether a standalone allocation outside of emerging markets may be warranted.
How can investors access A-shares?
The A-share market is conducive to active rather than passive management for a number of reasons
Market coverage
The A-share market is comparatively under-researched, with almost 70% of companies covered by three or fewer analysts. This provides opportunities for active managers to uncover underappreciated investment opportunities.
Index representation
The MSCI A-Share Index captures only a very small proportion of the investable universe. As a result, active managers can invest in more idiosyncratic and less efficient areas of the market, which provide stronger diversification benefits.
Investor base
The A-share market is dominated by retail investors who account for over 80% of market turnover. By contrast, retail investors account for only 5% of UK equity market turnover and 10% of US equity market turnover. Generally speaking, retail investors are sentiment driven and have short investment horizons, leading to higher volatility and periods of mispricing that active managers can exploit.
Despite the opportunities afforded by the A-share market, investing in China is not without risks.
Market volatility
The A-share market has historically been prone to high levels of volatility given the presence of retail investors. In recent weeks, Chinese technology and private education stocks have plunged as investors continue to digest the regulatory crackdown on the private sector.
State-owned enterprises (SOEs)
SOEs account for around half of the Chinese equity market (as measured by market capitalisation). While the proportion of SOEs has declined in recent decades, they continue to dominate strategic industries, eg banking, defence. A key concern is that the interests of minority shareholders will be secondary to the strategic objectives of SOEs.
Trading suspensions
Trading suspensions are a regular occurrence and can result in shares being suspended for months at a time. In November 2018, the China Securities Regulatory Commission announced a series of principles to help improve communication and transparency and avoid long-term trading suspensions.
Sustainability
China emits more greenhouse gases than the entire developed world combined, and its emissions have more than tripled over the last three decades, driven by the country’s urbanisation boom. To address this issue and help attract foreign investment, China is pushing to change its perception globally, eg vowing to be carbon neutral by 2060.
Following China’s economic reforms in the late 1970s, more than 800 million people have been lifted out of poverty. Today, less than 0.5% of the population fall below the poverty line, compared to around two thirds in 1990. The rate of change has been rapid and the investment opportunities that exist within China, and other high growth areas of emerging markets, may be fleeting. If you invest in equities, you should review your portfolio to make the most of these now, as well as plan ahead to see where new opportunities may emerge in the future.
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