Investors ponder China's role in equity asset allocations

China's growing economic strength and improving market accessibility may potentially bring significant investment opportunities, as well as challenges, to global investors. Understanding China's role in equity allocation may be crucial to sound investment policy decisions.

Under a classic asset allocation framework, investors typically have two objectives in mind when investing in an asset class or segment. The first is to improve the expected return of the portfolio, while the second is to improve portfolio diversification.

As for the first objective, China's purchasing power overtook the United States in 2014 and is forecast to be 1.5 times the size of the US by 2024, according to the International Monetary Fund.

This drastic shift in the balance of economic power may have significant implications for investors' equity portfolios if they seek exposure from financial assets that may benefit from this growth trend.

As for the second, China's A shares historically have exhibited low correlations with the rest of the world. From December 2008 to April 2019, the MSCI China A Index's correlation to the MSCI ACWI Index, MSCI's flagship global equity index, was roughly 40 percent, much lower than any other major MSCI regional indexes.

Based on the merits of Chinese equity assets, ruling out the segment from asset allocation could mean a loss to global money managers.

China would have only a 6-percent weight in the MSCI ACWI Index upon full inclusion, based on pro forma data as of April 2019.However, despite China's low weight in the global index, carving out China completely would have reduced the sustainable growth rate of the benchmark index by about 13 basis points in this hypothetical example.

Using the same analysis and historical data, although fully including China A shares in the MSCI Emerging Markets Index would not have significantly changed the sustainable growth profile of the integrated EM asset class, it would have lowered benchmark risk, thanks to China A shares' diversification benefits.

Have global and emerging market investors caught up with this fast-changing reality?

Evidence suggests that investors have only started to reconsider the place of China in their equity allocations, particularly since June 2017, when MSCI announced its decision to partially include China's A shares in the MSCI Emerging Markets Index and the MSCI ACWI Index, among other indexes.

Prior to MSCI's June 2017 announcement that it would include China's A shares in the MSCI Emerging Markets Index at a 5-percent inclusion rate, there were about 1,700 Stock Connect accounts through which investors gained exposure to China A shares. This increased to more than 7,300 following the announcement to increase the weight further.

Despite a marked increase in China allocations made by global equity mutual funds starting in 2017, global funds remained underweight in Chinese stocks compared to the MSCI ACWI Index. China's role in EM allocations has been considerably higher, but still lagging the index on average

Whether in global or emerging-market funds, this consistent underweight may be due to various investors' concerns, such as China's macroeconomic risks, lower familiarity with the universe of stocks and limited access to risk-management tools.

As China's capital markets and financial infrastructure evolve, investors are likely to consider alternatives to the role of Chinese equities in their broader global equity opportunity set.

If China continues to improve its market accessibility and addresses remaining areas of investor concern, the inclusion ratio of China A shares may rise further and ultimately could reach 100 percent, at which point Chinese equities may comprise over 40 percent of the MSCI Emerging Markets Index.

At present, the inclusion ratio of China's A shares is 15 percent, after the second step of the weight increase of A shares effective in August. The third step is scheduled to take place in November and raise the inclusion ratio to 20 percent.

Some investors may believe China will grow in size and importance within the global equities framework, while others may not. They may have varying approaches to how they treat China within their broader global equity allocation.

Investors with a neutral or a mildly positive view on China, but who do not need to act urgently, could choose to grow their China exposure by simply sticking with their current policy benchmark - basically, by doing nothing. Any increase in A shares to the index theoretically would result in a larger China allocation as these investors would seek to remain neutral (or close to neutral) to the benchmark.

Investors with positive convictions about the long-term prospects for China's economic growth or a bullish view of China's equity markets may wish to raise their exposure quickly. This implies a higher China exposure than the global equity benchmark.

Investors who are less certain about the implications of adding China A exposure to an existing emerging-market portfolio may consider delaying the decision to add China A weight. Those less convinced of the prospects for China's growing economic global role or the long-term trajectory of its equity market, meanwhile, may completely carve out Chinese equities from their investment benchmarks.

In terms of investment strategies, we at MSCI Inc's China Research department found that though not indicative of future results, factor-based quantitative strategies delivered better relative performance in the Chinese equity markets than elsewhere in the world.

Also, integrating environmental, social, and governance or ESG criteria for screening investments historically enhanced return more in China than in developed markets.

No matter what approach global institutional investors take to allocating Chinese equities, the significance of China may considerably impact their asset allocation and portfolio implementation approaches. The importance of understanding China's role in equity asset allocations cannot be underestimated anymore.

Wei Zhen is head of China Research at MSCI Inc, a global provider of investment indexes and analytics.