Lazard Insights. China A-Shares: A New Chapter for EM Investors. Summary. John Burge, Director, Product Manager

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1 Lazard Insights China A-Shares: A New Chapter for EM Investors John Burge, Director, Product Manager Summary MSCI s recent announcement regarding A-share inclusion in the Emerging Markets Index opens a new chapter for investing in China Over time, China could represent nearly 4% of the Emerging Markets Index Low correlation of the China A-share market to other major global equity markets suggests that adding China A-shares could help improve portfolio diversification Wide dispersion of returns among the A-shares themselves may provide an opportunity to generate alpha MSCI s announcement earlier this year that they will include China A-shares in their Emerging Markets Index means that China, already a significant portion of the index, will, over time, become even more important. This development, officially starting in 218, opens up a broad, new opportunity set for emerging markets investors. In this paper, we will discuss the details of the MSCI announcement and how it increases China s importance in the MSCI Emerging Markets Index. More specifically, we will define the China A-share market, explain how their inclusion introduces a broad new investment opportunity set, and outline what we can expect for the inclusion process going forward. Finally, we will discuss what the potential impact will be for investors. Lazard Insights is an ongoing series designed to share valueadded insights from Lazard s thought leaders around the world and is not specific to any Lazard product or service. This paper is published in conjunction with a presentation featuring the author. The original recording can be accessed via

2 2 Exhibit 1 Relative Size and Liquidity of the China A-Share Market Top 1 Largest Stock Markets in the World United States China Japan Hong Kong United Kingdom Canada France Germany India Switzerland Market Cap (US$ Trillions) Top 1 Stock Markets with Highest Trading Value a United States China Japan United Kingdom Hong Kong Germany Korea India Australia France Canada Daily Volumes of Turnover (3-Month Average, US$ Billions) As of 14 October 216 a ADVT represents average daily value traded. Source: Bloomberg, UBS Quantitative Research What Is the China A-Share Market? China s onshore stock market, referred to as the China A-shares market, is a large, liquid market with approximately 3, stocks and a market capitalization exceeding $7 trillion, making it second only to the United States in terms of both market cap and traded value (Exhibit 1). These shares trade in either Shanghai or Shenzhen and exclude Chinese companies traded in Hong Kong (which are called H-shares) or Chinese companies traded only in the US market. The Shanghai and Shenzhen markets are both broad with substantial trading volumes. The Shanghai exchange has 1,1 stocks with a $4 trillion market capitalization and a free float of approximately 4%. Companies listed there tend to be old economy companies with over 6% being state-owned enterprises (SOEs). There is also a much heavier weighting to the financials sector stocks on this exchange. The Shenzhen exchange has 1,8 stocks with a market capitalization of $3.3 trillion, a higher free float (63%) than Shanghai s and SOEs represent only 25% of the traded stocks. The Shenzhen market has far fewer financials than Shanghai and a larger representation of technology, health care, and consumer companies. Shenzhen stocks tend to be private companies, which are growing faster and are more profitable than their SOE peers. For that reason, companies on the Shenzhen exchange tend to trade at higher earnings per share (EPS) multiples than those listed on the Shanghai market. Significance of China A-Share Inclusion MSCI, a global provider of equity indices, announced on 2 June 217 that China A-shares would be included in its MSCI Emerging Markets Index beginning in June 218. MSCI consulted with and received broad support from the institutional investor community following improvements made in A-share accessibility by Chinese authorities. Though the initial inclusion is small, with a 5% partial inclusion factor (or weighting) representing 222 companies and a.73% weight in the MSCI Emerging Markets Index, the total A-share market cap is $7 trillion. Hence, this is a market that is only beginning to be explored. Roadmap for Future China A-Shares Getting to this point has been a long journey. As early as 22, China began allowing foreign institutions to invest in the China onshore equity market, through its Qualified Foreign Institutional Investor (QFII) program. The cumbersome registration process associated with this program required institutional investors to obtain an allocation or quota from Chinese government regulators so that they could invest, but subjected them to capital controls as well as a number of other restrictions. Through multiple iterations and adjustments, there have been some improvements; however, it can still be a complicated process.

3 3 Despite working closely with Chinese regulators, MSCI was not entirely comfortable with the limited access the QFII program provided its clients. Therefore, China A-shares were excluded from the broader MSCI Emerging Markets Index. However, with the launch of the Shanghai-Hong Kong Stock Connect platform in 214, as well as other changes that China implemented in order to get A-shares added to the Index, MSCI became more receptive to the idea. Then, in 216, the Shenzhen-Hong Kong Stock Connect launched. The two systems combined to become China Connect, which essentially meant that foreign institutional investors could now more easily access over 1,4 stocks in the China A-share market without most of the prior capital controls. Exhibit 2 Evolution of the MSCI Emerging Markets Index MSCI EM Index Weightings 217 Other 46% This, in turn, led to the June announcement that A-shares would be included with a 5% inclusion factor (equating to approximately 73 basis points). The transition is expected to take place in two phases and will be completed by August 218. Interestingly, the transition process implies that the final weight of the China A-shares in the broader Emerging Markets Index could be as much as 14% (.73 divided by.5). Combined with the country s current percentage of about 27%, China s overall weight in the index could increase to 4% or so. However, the process will take time, and there are likely to be bumps along the road to full inclusion of the shares. For example, Taiwan and Korea took between six and nine years to reach their complete allocations in the Index. Other 35% Mexico 1% Brazil 25% Malaysia 29% 1988 Represents 1 countries with $52 billion market cap As of 19 June 217 Source: MSCI Taiwan 12% Korea 15% China 27% Represents 24 countries with $4.4 trillion market cap In 1988, the MSCI Emerging Markets Index started with only 1 countries and a market cap of $52 billion. The Index now comprises 24 countries with a market cap of over $4 trillion. Meanwhile, countries that were once considered the heavyweights in the Index such as Brazil, Malaysia, and Mexico have seen their representation tumble. Today, the top three countries are China (27%), Korea (15%), and Taiwan (12%), none of which were included in the Index in 1988 (Exhibit 2). That is a dramatic change in composition and shows the growing economic power of Asia. Exhibit 3 Inclusion Is Not Limited to MSCI Emerging Markets Index China Country Weightings (%) Jun 217 Aug 218 Also, China A-shares will be added to other indices besides the MSCI Emerging Markets Index (Exhibit 3). The shares will be included in the MSCI All Country World Index (ACWI) and the MSCI Asia ex-japan Index. Although the initial increase will not be dramatic, global investors as well as Asia-focused investors will also have China A-shares in their benchmarks for the first time. 1 MSCI Emerging Markets Index MSCI Asia ex-japan Index As of 19 June 217 Pro forma weights across indices in August 218 Source: MSCI MSCI All Country World Index

4 4 Exhibit 4 Large Market with Limited Institutional Participation and Few Foreign Investors Market Capitalization of Equity Holdings of Foreign Investors in Asian and Emerging Markets a Retail versus Institutional Trading Volumes b (%) (%) Institutional Retail 2 25 Hong Kong Korea Brazil Japan Russia 1.38 SZSE A-Shares H-Shares a SZSE as of 3 September 216, other data as of March 215. Source: CSRC, SZSE b As of 18 August 216. Source: CEIC, UBS-S Too Large and Too Liquid to Ignore While the size and liquidity of the China A-share market would indicate a certain level of sophistication among its investor base, it is actually a relatively inefficient market. Foreign investors have limited participation in China's equity market. In addition, retail investors account for approximately 85% of the average traded volume, and they tend not to focus on company fundamentals when making investment decisions (Exhibit 4). Instead, they often rely on rumors, share price momentum, or the latest headlines to drive their decisions. This should offer local and foreign institutional investors, who tend to focus on company fundamentals when making investment decisions, an opportunity to generate attractive returns in their portfolios. We expect this investor landscape may change over time, perhaps dramatically. This unique dynamic is likely to provide some compelling opportunities. First, in the local Chinese equity market, consensus EPS estimates are often unavailable, and when they are on hand, only 43% are within 1% of expectations. Also, they frequently underestimate actual results as many analysts typically exclude quarterly expectations for company earnings in their reports, indicating that having a solid in-house research team to evaluate the market could be a competitive advantage for an investor (Exhibit 5). Second, the low correlation of the China A-share market to other major global equity markets suggests that adding China A-shares could help improve portfolio diversification (Exhibit 6). Finally, the wide dispersion of returns among the A-shares themselves should give active investment managers an opportunity to generate alpha. Exhibit 5 In-House Research Can Provide a Competitive Advantage Reported EPS Results vs. Consensus since January 212 (%) CSI 3 <-5% -4 to -5% -3 to -4% -2 to -3% -1 to -2% -2.5 to -1% In-Line As of 18 August 216 Source: Thomson Reuters Datastream, UBS +2.5 to +1% S&P 5 +1 to +2% +2 to +3% +3 to +4% +4 to +5% >+5%

5 5 Exhibit 6 Inefficient Market Provides Opportunity High Dispersion of Returns in A-Shares a Constituents Monthly Returns (%, 7-Year Average Standard Deviation) Week Rolling Correlation to Global Equities b CSI 3 FTSE 35 HSCEI Nikkei 225 FTSE 1 S&P MSCI China Shanghai A-Shares Shenzhen A-Shares a As of June 217. Source: UBS b As of June 217. Source: UBS The Opportunity Ahead The China A-share market provides global and emerging markets investors with a new large, liquid opportunity set. There is the distinct possibility that Chinese stocks may eventually represent 4% of the MSCI Emerging Markets Index, reinforcing the country s continuing importance in the global economy. Low correlation to other major markets, wide dispersion of returns among A-shares, and the, at times, questionable lack of accurate consensus forecasts for companies in China provide an opportunity for active investors who do their analysis to add diversity and generate alpha for their portfolios.

6 6 This content represents the views of the author(s), and its conclusions may vary from those held elsewhere within Lazard Asset Management. Lazard is committed to giving our investment professionals the autonomy to develop their own investment views, which are informed by a robust exchange of ideas throughout the firm. Important Information Published on 21 September 217. This document reflects the views of Lazard Asset Management LLC or its affiliates ( Lazard ) based upon information believed to be reliable as of the publication date. There is no guarantee that any forecast or opinion will be realized. This document is provided by Lazard Asset Management LLC or its affiliates ( Lazard ) for informational purposes only. Nothing herein constitutes investment advice or a recommendation relating to any security, commodity, derivative, investment management service or investment product. Investments in securities, derivatives and commodities involve risk, will fluctuate in price, and may result in losses. Certain assets held in Lazard s investment portfolios, in particular alternative investment portfolios, can involve high degrees of risk and volatility when compared to other assets. Similarly, certain assets held in Lazard s investment portfolios may trade in less liquid or efficient markets, which can affect investment performance. Past performance does not guarantee future results. The views expressed herein are subject to change, and may differ from the views of other Lazard investment professionals. This document is intended only for persons residing in jurisdictions where its distribution or availability is consistent with local laws and Lazard s local regulatory authorizations. Please visit for the specific Lazard entities that have issued this document and the scope of their authorized activities. Equity securities will fluctuate in price; the value of your investment will thus fluctuate, and this may result in a loss. Securities in certain non-domestic countries may be less liquid, more volatile, and less subject to governmental supervision than in one s home market. The values of these securities may be affected by changes in currency rates, application of a country s specific tax laws, changes in government administration, and economic and monetary policy. Emerging markets securities carry special risks, such as less developed or less efficient trading markets, a lack of company information, and differing auditing and legal standards. The securities markets of emerging markets countries can be extremely volatile; performance can also be influenced by political, social, and economic factors affecting companies in these countries. Small- and mid-capitalization stocks may be subject to higher degrees of risk, their earnings may be less predictable, their prices more volatile, and their liquidity less than that of large-capitalization or more established companies securities. Certain information included herein is derived by Lazard in part from an MSCI index or indices (the Index Data ). However, MSCI has not reviewed this product or report, and does not endorse or express any opinion regarding this product or report or any analysis or other information contained herein or the author or source of any such information or analysis. Neither MSCI nor any third party involved in or related to the computing or compiling of the Index Data makes any express or implied warranties, representations, or guarantees concerning the Index Data or any information or data derived therefrom, and in no event will MSCI or any third party have any liability for any direct, indirect, special, punitive, consequential, or any other damages (including lost profits) relating to any use of this information. Any use of MSCI data requires a license from MSCI. None of the Index Data is intended to constitute investment advice or a recommendation to make (or refrain from making) any kind of investment decision and may not be relied on as such. RD199