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Reminder: Investors In China Beware

Shenzhen Stock Exchange building facade
photo of the Shenzhen Stock Exchange by Chris Yunker

Two recent news stories illustrate a principle that, if you’ve been paying attention, is not news at all: Western investors should be wary of investments weighted heavily toward mainland China.

First, as of the beginning of June, more than 200 Chinese companies were inducted into MSCI Inc.’s equity indexes. Investors shouldn’t expect a big effect right away, however. The indexes will only add a small slice of the stocks’ market capitalization for now; initially A-shares (stocks of Chinese companies incorporated on the mainland) listed in Shanghai and Shenzhen will represent only about 0.39 percent of the MSCI Emerging Markets Index, Bloomberg reported. That weighting will rise in September. MSCI will also incorporate mainland Chinese stocks into other indexes, including the China Index and the All Country World Index.

The second news item was a report in The Wall Street Journal that focused on Beijing’s role in the tranquil appearance of Chinese markets. Traders and brokers report that regulators have frequently stepped in to make markets appear less volatile, especially during important political events. Lin Yunan, an investor based in the city of Shantou, told the Journal that he received a government warning because his trades were too large and too frequent, and they occurred during the National People’s Congress in October. Other investors reported temporary freezes or trading bans after making large market moves.

At Palisades Hudson, we don’t invest in any funds tied to MSCI’s Emerging Markets Index, though we have invested in funds linked to the All Country World Index. The latter index is adding less than 0.1 percent of Chinese exposure, so for the time being we are not particularly worried by this change, but it still serves as a reminder to keep an eye on what is in your mutual funds.

Granted, investors who are drawn to emerging markets index funds should know they are inherently volatile; to an extent, they are designed to be risky, with the theoretical trade-off of larger returns. But as passive funds benchmarked to MSCI’s indexes shift, many active fund managers are also likely to adjust their holdings accordingly to avoid deviating from their benchmark. Investors across the board would be wise to keep an eye out for growing Chinese exposure in their portfolios.

This is because, as we have written before, China’s markets remain opaque and subject to government interference. Unlike stocks in the U.S. and Europe, Chinese stocks are largely traded by small investors rather than institutional money managers, which has historically contributed to market volatility in mainland China. And Chinese disclosure standards are generally still lower than those in the U.S. and Europe, even after the 2015 market wipeout that led to a temporary ban on initial public offerings and widespread trading halts.

This is why exposure to the Chinse economy is better pursued through other avenues, such as the Hong Kong Stock Exchange. Hong Kong’s exchange offers better disclosure and has long been open to foreign investors. As David Kuo wrote in an opinion column for The Straits Times, a popular Singapore newspaper, “you don’t need to buy Chinese shares to get some exposure to Chinese growth.” Chinese companies listed outside of China are generally better-regulated and less likely to be the targets of Chinese regulatory intervention.

MSCI has started including A-shares in its indexes in part because a trading program has facilitated two-way trading between Hong Kong and mainland China since its launch in late 2014. The program, “stock connect,” has helped to ease concerns over money managers’ ability to buy and sell at will. Stock connect does have a daily cap, but it was recently raised to 52 billion yuan (approximately $8 billion) for “northbound” purchases. MSCI has also cited China’s efforts to reform its capital markets and make them more accessible.

Prior to recent steps, only a small number of qualified financial institutions had access to Chinese stocks outside Hong Kong, but stock connect has broadened the pool of potential investors. Copley Fund Research found that, over the past year, 180 emerging market funds have collectively funneled around $1.2 billion into A-shares. All of this means that more outside investors will be able to hold Chinese stock soon.

Those investors will need to bear in mind that Chinese markets do not move purely due to the influence of supply and demand. This is not to say that everything about the Shanghai and Shenzhen markets is illusory; instead, it’s a reminder that the information investors can access may be incomplete or even inaccurate, and that Beijing’s political needs may cause unexpected ripples. Regulators regularly engaging in market interventions can distort asset prices and, over time, potentially hurt returns.

The Chinese economy is too big to ignore, but unless major changes make its markets more transparent and less prone to government meddling, foreign investors should proceed with caution.

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