Vanguard To Buy Mainland China Shares For $69 Billion EM Index Fund

Early last week, Chinese shares got a boost (because China’s millions of newly-minted, semi-literate day traders needed to be reassured after the Hanergy debacle) from three pieces of news. 

The headline grabbers were: a report (citing unnamed sources) that indicated the quota on the Shanghai-Hong Kong link would be abolished once a similar setup with the Shenzhen exchange is in place later this year, and the announcement of a so-called “mutual fund recognition” scheme that will facilitate cross-border mutual fund flows.

But some of the underlying momentum may have also been attributable to news that FTSE Russell will begin a gradual transition aimed at the eventual inclusion of Chinese A shares in global EM benchmark indices. An interim arrangement will involve two “transitional indices” that include Chinese mainland equities. 

Now, Vanguard is set to benchmark its $69 billion FTSE EM index fund against one of these transitional indices.

FT has more:

A surprise move by Vanguard to include onshore Chinese A-shares in its flagship emerging market fund will “put pressure” on other asset managers to follow suit.

 

Pennsylvania-based Vanguard, which has $3.3tn under management, has said its $50bn FTSE Emerging Markets exchange traded fund, the world’s largest such vehicle, is to adopt a 5.6 per cent weighting to mainland Chinese stocks.

 

The move follows last week’s decision by index provider FTSE Group to launch a new emerging markets index with an initial China weighting of about 5 per cent, which will run alongside its existing index that has no exposure to A-shares (see table).

 

Vanguard has opted to switch the benchmark for its ETF to this new FTSE index.

This is potentially quite significant. As you can see from the below, the move will mean a nearly 5% allocation to mainland Chinese equities…

...and, more importantly, will force other providers to follow suit…

John Kennedy, investment director of Harvest Global Investments (UK), a subsidiary of Beijing-based Harvest Fund Management, China’s largest institutional asset manager, said: “Everything I read post the [FTSE] announcement was that this was going to be ignored by the world and his wife, so this is potentially quite a revelation.

 

“To see somebody adopting it within the week is very very important indeed. It will have quite an impact because it’s a very prominent provider. I would expect others to follow.” Mr Kennedy, whose parent company manages $85bn of assets, about half of which is in A-shares, added:

 

“The direction of travel is quite clear. International investors have got to think about how they are going to access mainstream Chinese equities and fixed income”.

That said, there are significant logistical hurdles ahead:

Vanguard’s move is an early indicator of what is likely to be an avalanche of overseas investment into the mainland market in the years to come, with most foreign institutions currently having little or no exposure to A-shares.

 

The Shanghai and Shenzhen bourses are now large enough to account for 24.2 per cent of emerging market stock capitalisation, according to recent calculations by FTSE.

 

However the main index providers have shied away from including these A-shares in their benchmarks because of concerns over capital controls and access for foreign investors.

 

At present, foreign groups can invest in A-shares if they have a quota allowance under Beijing’s qualified foreign institutional investor or renminbi-denominated QFII schemes, for which just $125bn of allocations have so far been made, although this is increasing.

 

Vanguard was recently awarded a Rmb10bn ($1.6bn) allocation, which it will use to buy A-shares for the ETF and an umbrella fund, which between them have $69bn of assets.

Technical barriers to entry notwithstanding, the Shanghai and Shenzhen bourses are together large enough to account for nearly a quarter of EM market cap which speaks to the potential for incredible inflows once Beijing removes restrictions. 

If there is no correction in between, it is truly frightening to consider how large China's equity bubble will become if, as FTSE CEO Mark Makepeace contends, Chinese equities comprise 20% of global stock portfolios by 2018.

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Statement from Vanguard:

China A-shares in Emerging Markets Stock Index Fund

The addition of China A-shares to the Emerging Markets Stock Index Fund and its ETF share class, VWO, the world’s largest emerging-markets ETF, will provide investors with more complete exposure to a key emerging economy and the second-largest stock market in the world by market cap. With the world’s second-largest GDP, China accounts for 20% of global trade and 7% of global consumption4. China A-shares will represent 5.6% of the new benchmark for the Emerging Markets Index Fund. Vanguard5 recently received a quota for China A-shares, which provide exposure to China’s largest issuers and a level of diversification that isn’t otherwise available in the market.

China A-shares are equity shares in mainland China companies that are traded on the Shanghai and Shenzhen stock exchanges and are only available to foreign investors through regulated systems, including the Qualified Foreign Institutional Investor (QFII) and Renminbi Qualified Foreign Institutional Investor (RQFII) systems or the Shanghai Hong Kong Stock Connect program.

"As the first major emerging markets fund to add exposure to China A-shares, the fund will benefit investors with more diversification, deeper emerging markets exposure, and greater access to the growth potential of Chinese equities,” said Mr. McNabb.