International investors are increasingly recognising China A-shares as a crucial element within their investment opportunity set. Recall that MSCI first added large-cap China A-shares into its mainline benchmarks starting from May 2018. Since then, different index providers have been busy updating their definitions of what constitutes "China".
On February 28, 2019, MSCI announced it will further increase allocations to large-cap China A-shares in its mainline indices starting from May 2019. The three-step process will increase the inclusion factor from 5% to 20%. It will also include mid-cap China A-shares from November 2019. These changes will result in China A-shares weight in many of MSCI's key benchmarks increasing threefold. Most notably, China A-shares will move from representing less than 1% of the MSCI Emerging Markets Index to 3.3%, on a pro forma basis.
We've observed that flows into China A-shares ETFs seemed to have picked up around the inclusion implementation dates that were part of MSCI's first round of China A-share inclusion. It is worth reminding investors that China A-share inclusion is a journey that various index providers are taking and that each is taking a different path and operating at a different pace. In all cases, it is important for investors to focus on the long-term investment implications of these moves and understand they are part of the natural evolution of global markets and the indices that measure them.
Since MSCI's initial inclusion of China A-shares in May 2018, other index providers have also announced their plans to include China A-shares in their global indices. All these actions appear to support our view that international investors are increasingly recognising China A-shares as a crucial element within the investment opportunity set. The recognition is not limited to the equity market, China onshore fixed income is also gaining traction with investors.
This year is shaping up to be a busy one for China A-shares inclusion as MSCI, FTSE Russell, and S&P DJI will all be adding China A-shares to their indices. As a reminder, the implementation and timing of China A-share inclusion by various index providers will differ. It is important to understand how these indices might be affected and the timing of their implementation. By March 2020, after this latest round of announced inclusions is complete, China A-shares will account for anywhere from 3.3% to 5.5% of the MSCI Emerging Markets Index, the FTSE Emerging Market Index, and the S&P Emerging BMI. This would leave China offshore and onshore equities accounting for around 32% to 37% of the value of these indices.
Will ETF Inflows Increase?
Looking at May 2018, the month MSCI started including China A-shares, it appeared to be one of stronger months in the past two years in terms of net inflows into China A-shares ETFs domiciled in Hong Kong, Taiwan, and the US. In August 2018, MSCI's second stage in its initial inclusion to bring inclusion factor to 5%, there were some net inflows into China A-shares ETFs domiciled in Hong Kong, Taiwan, and the US, while Europe-listed ETFs saw net outflows. Observing China A-share ETF flows around these two inclusion implementation dates suggests there may be some effect on flows, but given that we are dealing with just a pair of data points, we cannot form a definitive conclusion as to whether these events are impacting demand for these funds.
These are still just the first steps down the path towards integrating Chinese onshore equity markets into the global capital market. This next stage in MSCI's inclusion plan will increase the inclusion factor to 20%, taking it just a fifth of the way towards what is presumably its ultimate destination of full inclusion. With the longer-term view in mind, the mix of China A-shares in international indices will likely continue to increase. Investors should focus on the merit and investment implications of China A-share inclusion, rather than the flows. Specifically, investors should understand when and how the indices' inclusions may change the composition of the ETFs and index funds that track them.