This week MSCI made the decision to begin including Chinese A-shares (those listed on mainland exchanges) in their Emerging Markets (EM) Index starting in mid-2018.  Parametric has long argued against this inclusion, primarily on the basis of how large the allocation can grow, given the various access and investor protection issues these markets present.  This recent decision by MSCI, which seemingly goes against their own provisions for index inclusion, has done little to change our minds.

When making their recent decision for the inclusion of A-shares into their index, it appears that MSCI primarily focused on the size of the Chinese marketplace, rather than on the lack of investor access and protections.  Indeed, in its 2016 review, MSCI set forth three obstacles to inclusion of A-shares: restrictive repatriation limits, lax trade suspension provisions, and pre-approval requirements for financial products linked to A-shares. They stated these obstacles needed to be addressed in order for progress inclusion to occur.  However, the recent inclusion proceeded despite none of these obstacles having been remedied. MSCI offered only bland assurances that this decision had the support of international investors.

It is only fair to note that Parametric does hold A-shares in its Emerging Markets strategy.  This inclusion followed a boisterous debate, where we considered the pros and cons of including A-shares in a diversified emerging markets portfolio.  On the plus side, A-shares have historically demonstrated low correlation with Hong Kong listed shares, as well as the equities of other emerging market countries, yielding a diversification benefit to the broader portfolio.  Also, the A-share market allows an investor access to a broader representation of economic sectors within China then available from non-mainland exchanges.  On the negative side, there exists material currency repatriation risk with respect to the Chinese yuan, and market access and investor protections are extremely primitive when compared to other emerging markets.  

While these negatives are a concern, underdeveloped market conditions on their own do not disqualify A-shares from inclusion in our strategy. Our firm has invested in the least developed capital markets for over twenty years, incorporating static allocations to a large number of frontier market countries.  If we re-frame the A-share decision as, “are Connect-listed A-shares riskier than a frontier market country,” it is obvious that they are not.  However, as past events have demonstrated, they are also not substantially less risky.  By treating A-shares like we would any other frontier market (which we believe is the closest analogy), we believe a small position (roughly 1-2 per cent) best balances the diversification benefit of A-shares with the inherent political, economic and liquidity risk one takes on when investing in mainland exchanges.  It is with regards to this sizing decision where we stand in strongest opposition to MSCI.

As it stands, the current inclusion plan from MSCI starts with an allocation to A-shares of about 0.7 per cent in the MSCI EM Index. Then as market conditions are liberalized, this allocation grows to as much as 15-20 per cent. While this initial allocation appears appropriate, as it increases investors would be well-served to make sure that they are in agreement with the assessment of the index providers. If not, they should move to either a benchmark, which excludes A-shares (MSCI currently states they will continue to provide such an index) or to a strategy whose A-share sizing best reflects their opinion.  To do otherwise would amount to blindly accepting a major allocation to a market, which has historically shown little interest in the rights of foreign investors. 

About the firm:
Parametric offers a variety of rules-based investment strategies, including alpha-seeking equity, alternative and options strategies, as well as implementation services, including customized equity, traditional overlay and centralized portfolio management. Parametric is a majority-owned subsidiary of Eaton Vance Corp. and offers these capabilities through investment centers in Seattle, WA, Minneapolis, MN and Westport, CT. 

Disclaimer:
This information is intended solely to report on investment strategies and opportunities identified by Parametric. Opinions and estimates offered constitute our judgment and are subject to change without notice, as are statements of financial market trends, which are based on current market conditions. We believe the information provided here is reliable, but do not warrant its accuracy or completeness. This material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. Past performance is not indicative of future results. The views and strategies described may not be suitable for all investors. Investing entails risks and there can be no assurance that Parametric will achieve profits or avoid incurring losses. Parametric does not provide legal, tax and/or accounting advice or services. Clients should consult with their own tax or legal advisor prior to entering into any transaction or strategy described herein.

Global market investing, (including developed, emerging and frontier markets) carries additional risks and/or costs including but not limited to: political, economic, financial market, currency exchange, liquidity, accounting, and trading capability risks. Future investments may be made under different economic conditions, in different securities and using different investment strategies. The currency used in all calculations is the US dollar. Currency exchange may negatively impact performance.

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