The latest spasms in Chinese stocks have many investors running for the exits. But some analysts are keeping their eye on the big picture.

Morningstar has just published a research report about investing in Shanghai- and Shenzhen-listed stocks, known as China A-Shares.  Titled “China Opens ‘A’ Door for Foreign Investors,”  the report by Morningstar senior manager research analyst Patricia Oey notes that the $3 trillion Shanghai and Shenzhen equity markets have increasingly become open to foreign investment, prompting the likely inclusion of China A-Shares in MSCI’s and FTSE Russell’s global equity indexes—and the index funds that track them—in the coming years. In addition, Oey points out that Vanguard recently announced it will add China A-Shares to its emerging markets index fund and ETF starting later this year.

“Over the past few years, China has implemented a number of initiatives to allow for controlled foreign fund flows into its onshore equity markets, as part of its goal to gradually liberalize its economy,” Oey writes. “Index providers MSCI and FTSE Russell are monitoring these efforts and currently have Shanghai- and Shenzhen-listed stocks, also known as China A-Shares, on a watchlist for inclusion in their respective global equity indexes.”

The analyst acknowledges that adding China A-Shares at this time would have minimal effect on global and international equity indexes, as China accounts for a very small percentage in these benchmarks. On the other hand, Oey notes that adding China A-Shares would have a major impact on emerging-markets indexes. China already accounts for 25%-30% (via Hong Kong-listed Chinese stocks) in broad emerging-markets equity benchmarks, so the addition of China A-Shares would result in a much larger China allocation.

Emerging-markets funds are already opening their doors. “Both MSCI and FTSE Russell plan to add China A-Shares in a gradual fashion, where China A-Shares would initially account for a single-digit percentage of their respective emerging-markets indexes,” Oey said. “Over the long term, as China continues to open access to its markets, China A-Shares could account for 20%- 25% of an emerging-markets index, for a total China allocation, including Hong Kong-listings, of 40%- 50% (using prices as of June 30, 2015).”

Vanguard has seen the writing on the wall and is getting a jump on this possible benchmark change (and potentially large foreign fund inflows) by announcing that it will add China A-Shares to its emerging-markets index fund, Oey says.

Vanguard Emerging Markets Stock Index Fund (VEIEX) and (VWO) currently tracks the FTSE Emerging Index. But the report says it will switch later this year to an index that includes China A-Shares at a capped level. This China AShare allocation will rise gradually as China liberalizes foreign investor access to its equity markets.

Now here comes the Surgeon General’s Warning on Chinese stocks: “Investors may be concerned about a large allocation to China. Most listed Chinese companies are government-controlled firms, and at times, state interests can take precedence over profitability,” Oey said “The government maintains a very heavy hand in the market, as it recently helped fuel an equity market bubble, only to have to take aggressive measures to try to mitigate a subsequent slide. China is also trying to implement a wide range of economic reforms, as well as manage a slowing economy. There is regulatory uncertainty regarding how China plans to meet these goals, and this continues to be a significant source of market volatility. Investors who hold emerging-markets index funds should consider if they want a potentially very large exposure to Chinese equities within their fund.”

Should they worry about a large China exposure? Check back with Asia Unhedged in a few months.

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