China and MSCI: Index Inclusion Creates Illusion of Grandeur

The odds are tilting toward MSCI including Chinese domestic shares in its indexes but investors should be wary of the hype

By Jacky Wong

MSCI is expected to make a decision later this month on whether to include shares listed on China’s domestic exchanges. Above, the Pudong financial district skyline from the historic Bund in Shanghai. Photo: Agence France-Presse/Getty Images

Passive investing means investors don’t need to worry about picking stocks. But MSCI, one of the biggest index compilers, is considering a big stock pick that should make investors tracking its indexes nervous.

MSCI is expected to make a decision later this month on whether to include shares listed on China’s domestic exchanges, also known as A shares. The inclusion was widely expected one year ago and MSCI’s surprise decision to put the matter on hold partially precipitated last summer’s market meltdown.

In theory, being accepted into MSCI’s exclusive club would mean more institutional investors in China’s notoriously retail-driven markets. It would also mean billions of dollars flowing to China’s markets from funds benchmarked to MSCI indexes. China’s A shares would make up of a fifth of the MSCI Emerging Markets index in a full inclusion. Goldman Sachs GS 0.31 % estimates around $1.5 trillion of assets, both active and passive, are tracking the index.

So China has been working hard over the past year to iron out concerns raised by MSCI. It made its market more accessible to foreign investors in February by expanding investment quotas and easing capital restrictions.

Last Friday, China’s two domestic exchanges published guidelines to regulate trading halts in the markets. At the peak of the market crash last summer, over half of the stocks in the Shenzhen and Shanghai bourses were suspended. This spectacular episode has caused worries that investors may not be able to cash out of the markets when they want to.

The latest attempt to appease MSCI before its verdict seems to have convinced some that an inclusion could happen. Goldman Sachs raised the probability of an inclusion to 70% from 50% estimated in April. Money is flowing into A-share exchange-traded funds and Chinese markets had their biggest jump in nearly three months Tuesday, partially on hopes for inclusion.

Investors should be wary of the hype. The initial impact would be very small even if MSCI decided to pull the trigger. Inclusion would still be a year away and even then, initially the weighting would only be 5% of a full inclusion. Estimated inflow linked to the initial inclusion will be less than one day of average turnover.

And then there’s the issue of what investors would be getting themselves into. China’s A shares trade at a 35% premium to their Hong Kong-listed shares for dual-listed companies. China’s biggest oil firm, PetroChina, for example, is 63% more expensive in Shanghai than in Hong Kong. Hong Kong and U.S.-listed Chinese stocks are already included in MSCI indexes.

It also doesn’t take into account China’s checkered regulatory record, highlighted last summer by a bumbling market intervention. That episode revealed that, deep down, many of China’s economic leaders hold a shallow level of trust in investors, let alone liquid markets in general.

China may get into this coveted club, but that doesn’t mean everyone else should want to play along.

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