Index provider MSCI’s decision to include some China A Shares in its indices is symbolic but will not have an immediately significant impact, according to Liontrust’s Mark Williams.
Williams, who co-manages the £111.3m Liontrust Asia Income fund alongside Carolyn Chan, said the partial inclusion limits the immediate impact on indices. 
Last year the index provider announced it would include China A Shares – those that are traded on China’s onshore stock exchanges in Shanghai and Shenzhen – in the MSCI Emerging Markets index.
The index provider has done so through a two-step inclusion process with 2.5 per cent of the A Shares added to indices initially, which will rise to 5 per cent in September.
As of June 2018, a total of 234 China A Large Cap stocks will have been added to the MSCI Emerging Markets index.
By September 2018, Chinese A Shares will represent approximately 0.78 per cent of the weight of the MSCI Emerging Markets index.
A Shares weighting in the MSCI Emerging Market index
Source: Liontrust
“According to the World Federation of Exchanges the two mainland exchanges for A Shares, Shanghai and Shenzhen, have market capitalisations of $5.1trn and $3.1trn respectively,” said Williams. “This puts the country on a par with the world’s larger exchanges.
“In Asia, the Japanese exchange alone is slightly bigger ($6.2trn); Euronext, the largest exchange in continental Europe – with a capitalisation of $4.4trn – is smaller than Shanghai, making the US exchanges – the NYSE and the NASDAQ – the only ones with significantly greater scale,” the manager added.
However, the manager noted this inclusion is “symbolic” rather than immediately significant, as the partial inclusion restricts immediate impact on indices.
He said: “These A Shares will initially only be added at 2.5 per cent of their potential full weight, moving up to 5 per cent at the next quarterly index change on 1 September. This partial inclusion approach means that the changes to MSCI indices will initially be negligible.”
Williams noted MSCI has estimated that A Shares – following the September 2018 increase – would only account for 0.1 per cent of the MSCI AC World Index, with other Chinese equities making up 3 per cent of that index.
“The shares will represent 0.8 per cent of the MSCI Asia excluding Japan index, where China’s weighting is 33 per cent, and 0.7 per cent of the MSCI Emerging Markets index versus 29 per cent for other Chinese equities,” he explained.
Although the initial impact on the index won’t be very significant, Williams believes accessibility to these markets are likely to increase further, which will give greater prominence to the A Share market.
“One of the main improvements to accessibility over recent years has been the introduction and growth of Stock Connects allowing investors in Hong Kong to buy mainland A Shares and the corresponding purchase of Hong Kong-listed companies by those on the mainland,” the manager said.
“There are currently two Connects with mainland China, Shanghai-HK and Shenzhen-HK, and there has been a proposal for a Shanghai-London Connect to be opened later this year,” Williams added.
A Shares weighting in the MSCI Emerging Market index if fully included
Source: Liontrust
As such, if the MSCI decided to increase the A Share inclusion to 100 per cent by also including mid-cap shares, the China A Shares would account for around 17 per cent of the MSCI Emerging Market index, the manager noted.
“Such a prominence of A Shares within MSCI indices would clearly be significant, both for passive investors looking to replicate them and for active investors such as ourselves who seek to outperform them,” Williams said.
Highlighting the expensive valuations of domestic Chinese equities, the Liontrust Asia Income fund manager said the team holds no A Shares in the fund, as they are finding more opportunities outside that market.
Williams said: “The Shanghai Composite and Shenzhen Composite trade on prospective price/earnings [P/E] ratios of 12x and 20x respectively.
“In the Liontrust Asia Income fund we currently invest in Hong Kong-listed shares of Chinese companies with our exposure trading on an aggregate P/E of 11x, less than the Hong Kong-listed companies index and also less than the A Shares.”
A good illustration of the high valuations of Chinese A Shares, Williams said, is the Hang Seng China AH Premium Index.
The index measures the share price premium or discount of A Shares over H Shares – Chinese companies’ shares traded on the Hong Kong Stock exchange – for some of the largest China companies with both A Share and H Share listings.
As the chart below shows, A Shares currently trade at a premium of over 20 per cent to their corresponding H Shares.
A shares premium over H shares
Source: Liontrust
Williams said: “Although there are a number of companies that have listings in both markets, equities in one company cannot be transferred between markets and so there is no scope to arbitrage significant price differences.
“Part of the reason for the lofty valuations of A Shares is that you have a group of domestic Chinese savers who have few alternatives in which to invest their money, despite the improving access to Hong Kong via the Connects.”
He added: “Bloomberg estimates that individual retail investors account for 80 per cent of trading volume in mainland China.
“We believe that this increases the influence of investor sentiment compared to fundamentals in the market.”
But as Chinese exposure to the international market increases, Williams believes fundamentals will become more assertive, with a narrowing of the A Share/H Share premium signalling domestic investor sentiment is having less influence on stock movements.