Investors face a tough choice over China index changes
China’s ongoing efforts to bring defiance in Hong Kong to heel is raising a difficult question for investors: should they stick or twist?
The US government and several senior politicians in Congress want US investors to pull back from equity investments in the country. At the same time, most index providers look set to increase the weighting of China A-shares in their global and emerging market benchmark indexes.
That means almost all passive investors, which includes major pension funds in their ranks, will have to invest a lot more into China’s stock market over the next two years. Some market experts feel this would be a potentially risky thing to do, given escalating US and China tensions.
US pension funds are already under pressure for tacitly supporting China’s growth despite its failings as a global citizen. Asset owners in Asia and other parts of the world may face similar political pressure if China continues to throw its weight around in the region.
The scale of the problem is only set to worsen.
In 2019, changes in benchmark indexes led to nearly $400 billion of new foreign investment into Chinese equities. Similarly, global bond indexes have started adding Chinese government bonds to their benchmarks and accounted for an additional investment flow of over $100 billion into China.
HSBC has estimated that index rebalancings could cause US investors to allocate more than $1 trillion to China by the end of 2021.
ON THE MERITS
There can be little financial argument that China should account for a larger portion of global equity indexes.
While the country has the second largest economy in the world, it only has a 4.7% weighing in the MSCI All Country World Index. The US accounts for almost 58%.
In contrast it holds a much larger position in emerging market indices – comprising 39% of the MSCI Emerging Markets, for example, and 37% of equivalent indexes by FTSE Russell and S&P Dow Jones.
MSCI has already come under fire for bowing to pressure from China to increase the weightings of A-shares, even though it is doing so on a gradual scale. According to Caroline Yu Maurer, China equity strategist at BNP Paribas Asset Management, the competing pressure from the US and Chinese sides mean index companies are most unlikely to bow any further in either direction.
“For MSCI now to say the past inclusion is not counted and we have to reverse back to exclude everything – the likelihood of that is very low,” she said.
“And from the investor point of view, whether or not we see an increase in index weightings this year, it will be difficult for the US government to tell MSCI they are not allowed to increase the weighting to China.”
TIGHT-LIPPED APPROACH
The index firms are acutely aware of how politically sensitive their China investment allocation decisions have become.
AsianInvestor reached out to MSCI and S&P Dow Jones. MSCI refused to comment on the record. S&P Dow Jones was barely less tight-lipped, saying only that it offers versions of its benchmarks that exclude China A shares – or Chinese equities entirely – for investors wanting to eliminate the country from their portfolio.
Yu Maurer believes MSCI may take a more prudent approach to its index decisions in future, not least because of the pressure from the US side.
“The inclusion criteria involves them talking to many different investors before making their decisions about whether to increase the weightings for China. If they are doing that now, they may find they get more expressions of concern due to the worsening of the US China relationship.”
This would reflect current thinking among foreign investors, according to Alicia Garcia Herrero, chief economist for Asia at Natixis.
But avoiding China is not an option, say asset owners. The common refrain from managers and trustees of pension funds is that they would be failing to discharge their fiduciary duty to maximise returns for their members if they ignore Chinese companies.“It is true that foreigners are not as keen on the Chinese market, as far as the riskier part is concerned. Net inflows into the stock market have slowed down substantially as well as those into credit, while those into government bonds have increased.”
Calpers, the largest state pension fund in the US, holds $3.1 billion worth of shares in Chinese companies. It has been under great pressure from the federal government to divest, but stated its position in a recent response to the controversy.
“In 2019 we rebalanced our portfolio, resulting in the removal of 143 stocks and the addition of 198 stocks,” Calpers said in a statement on its website. “Nearly half of the companies added were Chinese companies, given the changes made by the index providers to include China A-shares. This was not an active decision made by us.”
However, it has since been revealed that Calpers runs a custom China index and doesn’t therefore make entirely passive decisions on its China allocations.
Yup Kim, a senior portfolio manager with the $67.21 billion Alaska Permanent Fund Corporation in the US, said the investment team considers political risks as part of their research and review processes.
“If you look at institutions who have invested in emerging markets in the past few decades, there are sometimes cases where states will take private companies and expropriate them. That is a risk you take,” said Kim.
But he suggests that prudent investors are able to find plenty of investments away from areas that could be deemed politically sensitive.
However, he noted the country’s international growth ambitions also limit the amount of financial damage it would be prepared to be responsible for.
“China wants to create a regional hegemony. They want to be a leader and you don’t become a leader by having investors’ money evaporate to zero. There’s too much at stake.”.”