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Implications of China A-shares global inclusion

By: Mat Lystra, senior research analyst

In part one of this two-part series, we discussed China’s progress from an inward facing economy to becoming more global—through the development of its many share classes. We learned that despite such progress the majority of China’s economy, as represented by the domestic A-share class, is still heavily restricted for foreign investors. This leaves most global indexes and portfolios with an incomplete exposure to the Chinese equity markets. It also begs the question: what effect would A-share inclusion have on the global equity landscape?

In this blog post we’ll take a closer look at how each of China’s seven primary share classes relate to each other and to the more mature US equity market. All of China’s share classes, with the exception of A-shares, were developed to provide offshore investors with the ability to access the Chinese economy through various means. B-shares are traded within China but are settled in Hong Kong or US dollars. Red-chips, P-chips and H-shares are traded on the Hong Kong stock exchange (HKEX), and S-chips and N-shares are traded on the Singapore and New York stock exchanges respectively.

Despite sharing a country of origin, the seven share classes do not move in lockstep. The correlations between share classes are relatively low due to the unique characteristics of each. Generally, the highest correlations are found among the three share classes that trade on the HKEX—ranging between 0.79 for H-shares and P-chips and 0.88 for H-shares and red-chips. As we can see in the graphic below, A-shares display much weaker relationships with all but the one other China-based class, B-shares. These relationships can be useful information for managing diversification at a portfolio level.

Correlations with China’s A-Shares from December 2006 through June 2016

 

Source: FTSE Russell. Data as of June 30, 2016. Past performance is no guarantee of future results. The dates shown represent the date range in common with all share types. Please see the end for important legal disclosures.

Another important revelation that comes out of this matrix is the correlations of each China share class with the US equity market as represented by the Russell 3000® Index. With N-shares being listed in New York, it should be no surprise that they have a moderate correlation to the US equity market. All of the other share class types have fairly low correlations to the US, with A-shares being the lowest at 0.30—again, not a surprise because of the low integration of A-shares in the global equity market. For now, A-shares offer diversification for developed market-oriented portfolios, but this is likely to change as A-shares are increasingly brought in to global portfolios.

A primary reason for the low correlations among China’s various share classes are the inherent differences in sector composition. For example, as we can see below, H-shares have a large skew towards the financials sector as Chinese banking/insurance institutions tend to list on the HKEX to gain access to overseas capital. Sector concentrations among other share classes reflect certain industries’ efforts to skirt China’s controls over certain areas of the economy. The share class that represents the broadest swath of the Chinese economy is the A-share class, which comprises more than two thirds of the total Chinese equity market. This makes the case for its global inclusion even more compelling.

Historical averages of ICB sector weightings across China’s share classes

Source: FTSE Russell. Represents the historical averages from sector weights as of December 31 from 2004-2015. Data as of June 30, 2016.  

To gain a glimpse of what a “total” China portfolio might look like, we created two hypothetical portfolios. We’ve assumed that due to the nature of A- and H-shares, that a “total” China portfolio would not include both simultaneously.[1] The total sector exposures for each of the hypothetical “total” China indexes are below. If we ignore the accessibility issues of A-shares for the sake of this analysis, we can assume that A-shares are the most comprehensive representation of the China-based equity market—represented by the “ex-H-shares” burgundy colored bars below. As compared to a mature economy like the US where the technology and healthcare sectors each have a weight of approximately 15% within the Russell 3000, the modest weights in these sectors seen in our hypothetical “total” China portfolios have room to grow.

Averaged ICB sector weights within simulated ex-H-shares and ex-A-shares indexes

Source: FTSE Russell as of June 30, 2016. Each sector weight represents the 2004-2015 average of the summed products of the ICB sector weight and corresponding share class weight (excluding H-shares or A-shares) as of December 31. Past performance is no guarantee of future results. Please see the end for important legal disclosures.

We have now seen that for the Chinese economy to be fully represented in global indexes and portfolios, A-share inclusion is critical, and our analysis has hinted at industries that are likely to grow as China’s demographics change. This is why A-shares continue to feature so prominently on FTSE Russell’s “watch list” for classification as an emerging market, the condition which would allow A-shares into the applicable global and emerging market indexes.

Please see China through the mosaic of its share classes for a more detailed analysis on this topic.

 

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[1] For more explanation on A- and H- shares please see Capturing pricing anomalies China A- and H- shares.

 

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