MSCI Set to Include Chinese Big Caps, But Growth May Be Elsewhere

The 222 large-cap stocks being included in emerging market ETF are largely part of the old Chinese economy.

Investors will be able to access some Chinese stocks through MSCI’s Emerging Market ETF next year. But whether they would want to is another matter.

On Wednesday, and with much fanfare, MSCI announced a long-awaited decision to start to include 222 large cap A shares traded in mainland China in its benchmark emerging market index. MSCI has been debating the inclusion for four years, and the decision was seen as steering capital into the Chinese economy and expanding opportunities for investors.

But while high on symbolism and good for the Chinese economy, the move may be much less impactful to institutional investors where it matters most: generating outsize returns.

“It would be a small step in the right direction of making indices somewhat more representative of the range of emerging market opportunities,” said Taimur Hyat, chief strategy officer at PGIM, a money manager with $1 trillion in assets under management. “But the indices are not the most relevant in terms of the highest alpha-generating opportunities in the emerging markets universe.”

Hyat points out that the 222 large-cap stocks are part of the old Chinese economy and skewed towards financials, formally state-owned entities, and old manufacturing and materials companies. The biggest companies to be included are the Industrial and Commercial Bank of China, China Construction Bank, PetroChina, Agricultural Bank of China, and Bank of China. While MSCI sought to include the largest and most-liquid stocks, they may be among the most stagnant as well.

PGIM’s local research shows the trends playing out that investors should capture to be represented by middle- and small-cap stocks instead. These include opportunities in the Chinese technology sector – particularly financial technology, where mobile payment systems are leapfrogging their developed-market counterparts – and consumer consumption driven by the wealth effect and rising wages. Travel, recreation, and other opportunities that come with a rising middle class are other areas where PGIM sees strong growth ahead.

Private asset classes including real estate and private equity present other pockets of opportunities far more compelling than the large-cap stock inclusion, Hyat says. “In terms of alpha generation, the large-cap exposure through indices just won’t move the needle.” For equities, Hyat says PGIM often looks to American Depository Receipts (ADRs) or companies with Hong Kong listings.

Many investors celebrating the move, meanwhile, may be placing too much emphasis on the past. Bin Shi, head of China equities at UBS Asset Management, applauded the “disclosure, corporate governance, and many other aspects of the A share market” the inclusion would bring in a comment to investors. “In return, global investors can benefit from many unique opportunities in the A share market, which could be quite rewarding as we witnessed over the last 10 years.”

The drivers of growth for the Chinese economy, however, are far from the same as a decade ago. The growth opportunities that were presented by an export-led, low-wage model to developed countries – and that drove much of the stellar big-cap performance over the past decade – have witnessed the rise of other trends.

Less competitive export and manufacturing amid higher Chinese wages as automation and protectionism abroad makes domestic, developed-market manufacturing more advantaged is chief among them, said Hyat. Meanwhile, the rise in consumer purchasing power as Chinese authorities attempt to transition from an export to a consumption model favor mid— and small— cap stocks.

Some of the most-exciting opportunities the firm sees are in financial technologies like payments, Hyat said. China never saw as extensive a brick-and-mortar buildout as developed markets in many industries. As a result, consumers often use mobile payments for increments as little as 20 cents at venues like farmers markets.

“Opportunities vary from period to period, and that’s why it is important to be forward looking,” Hyat said.

Investors may have exposure to Chinese large caps via the MSCI index next year. But don’t count on that translating to performance. 


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