It was one of the most significant developments in the financial markets…

In 2018, global index provider MSCI – which has trillions of dollars tracking its indexes – finally put China on the map.

It began including domestically traded Chinese stocks (called “A-shares”) in its Emerging Markets Index.

Up till then, the index’s China investments mostly stuck to U.S and Hong Kong-listed shares of Chinese companies… and for a good reason. They were easy to trade, which meant funds based on the index could track its performance closely.

But this easy way didn’t fully represent China’s economic heft. It excluded major Chinese companies that traded only on domestic exchanges in Shanghai or Shenzhen.

So, even though China accounted for 35% of gross domestic product (“GDP”) for emerging markets, Chinese stocks only made up 28% of the MSCI Emerging Markets Index. And almost none of that was in the A-shares market.

But China’s capital markets were opening up. It soon became just as easy for institutional investors to trade A-shares as any U.S. or Hong Kong-listed stock. That’s what allowed MSCI to add A-shares to its indexes in 2018.

By 2020, nearly 41% of the MSCI Emerging Markets Index was in mainland-Chinese stocks.

It was a triumph. But even with this change, Chinese stocks remain grossly underrepresented worldwide…

That will change in the coming years. And it’ll create an incredible tailwind for the Chinese market.

Let me explain…

The MSCI Emerging Markets Index is popular among fund managers. It’s tracked by an estimated $1.9 trillion in assets under management (“AUM”). And thanks to the Chinese A-shares inclusion, tens of billions of dollars of new investment has found its way into Chinese stocks.

Still, this is peanuts compared to the $4.8 trillion in AUM tracking the MSCI All Country World Index (“ACWI”).

As its name suggests, the MSCI All Country World Index represents the full opportunity set of large- and mid-cap stocks across 23 developed and 24 emerging markets.

So, you’d expect that each market is represented about on par with its GDP contribution to the overall basket. And for most countries, that’s true. Just take a look at the chart below…

This isn’t the case for China though…

Today, China is the world’s second-largest economy with a GDP equivalent to 17.9% of the global total. Yet, its weight in the MSCI ACWI is a paltry 3%… or 3.7% including Hong Kong.

And the U.S. market completely dominates the index. It has a 60.4% weighting. That’s more than double its share of global GDP.

Of course, there are good reasons for U.S. dominance in this popular index…

For one, the U.S. is the world’s biggest stock market. Between the New York Stock Exchange and the Nasdaq, it has a total market capitalization of $42.6 trillion. That’s 140% bigger than all of China’s stock markets put together, including Hong Kong.

It’s also the world’s best developed, transparent, and most easily accessible market. And it doesn’t hurt that it’s home to companies like Apple, Microsoft, Amazon, and Google’s parent company Alphabet… worth more than a trillion dollars each.

Meanwhile, China still has shortcomings despite its economic power.

Its currency, the yuan, isn’t freely convertible like the U.S. dollar. That makes it difficult for investors to move money in and out of the country.

Apart from institutional investors and qualified high-net-worth individuals, most foreign retail investors are unable to trade shares directly through Chinese stock exchanges.

China’s markets can also move a lot as a result of Beijing’s decisions. We’ve seen this in China’s regulatory crackdown on tech companies over the past couple of years.

All these factors make China’s markets riskier than the U.S. And they’ve kept it from taking a bigger slice of the $4.8 trillion in funds tracking the MSCI ACWI.

Things are going to change, though. Just like we saw in the Emerging Markets Index, it’s inevitable…

China’s capital markets are opening up more every year. Its exchange-traded-funds (“ETFs”) market is booming… And last month, Chinese regulators made the country’s ETF market accessible to foreign investors through Hong Kong. That’s creating more avenues for global investors to easily participate in Chinese stocks.

Finally, while it doesn’t seem like the yuan will become freely convertible anytime soon, Beijing’s determination to keep the yuan stable is an advantage to investors worried about volatile currency markets.

China’s weighting in the MSCI ACWI will not go from 3% to 17.9% overnight. In fact, it may never get to that level at all. But it can only go up from here.

That means hundreds of billions of dollars more will flow into Chinese stocks. It’s an incredible long-term tailwind… one that investors should consider getting ahead of soon.

Good investing,

Brian Tycangco

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Source: Daily Wealth