China’s Type A Approach

China lucky catHistorically, China A–Shares, which are listed on the Shanghai and Shenzhen stock exchanges, have been open to local Chinese investors only. The market, however, is now more open to foreign investors and A-Shares are becoming a compelling investment opportunity.

In 2002, the Qualified Foreign Institutional Investor (QFII) program was introduced, which allows foreign institutions to invest in the Chinese domestic market. There have been 266 QFIIs approved as of September 30, 2014, with a significant increase in approvals over the past two years. Chinese regulators announced an increase to the total QFII quota from US$80 billion to US$150 billion in July 2013 and current cumulative quota grants are at US$62 billion. However, total QFII shareholding accounts for only approximately 1.5% of the A-Share market compared to foreign ownership of 25% in Taiwan, 15% in Korea and 13% in India.

In China’s rapidly growing market, investors can benefit from the large undiscovered opportunity set and the potential for market inefficiency. Since 2012, the Shanghai Shenzhen CSI 300 Index dropped 7.5%, yet the median stock was up 6%.

China A-Shares have the potential to offer a better diversification opportunity because they are less correlated to global equity markets, reflecting the local nature of the investor base and revenue exposure. A-shares offer investors access to the domestic Chinese economy with its unique company and sector exposure. A-Shares also have compelling valuations, offering investors an attractive entry point.

Offshore Chinese equities are more focused on the financial, materials, energy, and telecom sectors, while A-Shares represent higher consumer, healthcare, and technology weightings. These A-Share sectors provide greater exposure to Chinese consumption growth. As the Chinese economy continues along its development path, the fixed asset investment-driven sectors represented by offshore Chinese equities will likely grow at a slower pace than the “New Economy” Chinese A-Share consumption themes.

The smaller market cap orientation of the A-Share universe provides investors with a greater opportunity for discovering relatively unknown companies. Most of the small Chinese companies do not list H-Shares or B-Shares, and there have been no new B-Share listings since 2001 with de-listings continuing today.

Since 2005, Shanghai-listed A-Shares have had just a 0.33 correlation to the MSCI World, less than half of that of H-Shares (those listed on the Hong Kong Stock Exchange) at 0.69. China A-Shares are the most important equity market of the Chinese economy. The combined market cap of H-Shares, B-Shares (that trade on the Shanghai or Shenzhen exchanges) and Red Chips (companies required to meet the filing requirements of the Hong Kong Stock Exchange) are approximately only 60% of the total A-Share market. Not only do they represent a significantly broader opportunity set but they also have six times the listings of other share classes combined.

The potential partial inclusion of China A-Shares in the MSCI Emerging Markets and ACWI Indexes at just 5% would imply inflows of US$10 billion, and US$3.1 trillion is benchmarked for these two indices. If inclusion occurs, the potential long-term benefits would be further opening to foreign investors, leading to improved corporate governance and better financial disclosure. This will promote a more mature market and result in convergence of valuation with global peers.

There are a few barriers to obtaining a GFII that should not be overlooked. The application process is cumbersome and can take several months. You must first apply for a QFII through a custodian, which can take three to five weeks. The format and investment plan submitted are very important to the China Securities Regulatory Commission (CSRC). The CSRC will assess the application and make a decision on whether or not you are a qualified entity—that can take up to a month. After you obtain your QFII, you must submit a quota application for approval; once your quota is approved, you can then open an account, transfer funds and start investing. However, there are a number of other caveats. For example, once granted a quota, you must fill it within a certain amount of time. Before trading can occur, there has to be account preparation, trial work and operational testing.

Casey Preyss is Partner and Portfolio Manager, William Blair & Company