There’s $1.7 Trillion Locked Out of China’s Stock Rally

China’s push to insert its stock market into the global financial system is coming too late for investors holding $1.7 trillion of developing-nation assets.

The benchmark gauge in China has soared 33 percent since August through last week, more than any other major market in the world, yet most developing-nation equity funds aren’t benefiting from the rally at all. In fact they’re plunging.

The problem is that while Chinese policy makers have taken some steps to free up capital flows, the moves haven’t gone far enough to persuade MSCI Inc. to include the country’s locally traded shares in its flagship emerging markets index. And if a market isn’t in the index, fund managers who benchmark their performance to the gauge typically won’t put money into it. With Chinese stocks listed in Hong Kong failing in their role as substitutes, Brazilian shares falling into a bear market last week and Russian stocks tumbling, not since 2010 has the lack of mainland China securities been felt so keenly by investors.

“This recent market rally has really been only local shares in China, and most of the funds, most of the ETFs out there, their Chinese exposure is mostly overseas listed companies,” Stephen Tu, an analyst at Moody’s Investors Service in New York, said by phone Dec. 12. “No matter how you measure it, China’s economic presence in the world is far greater than the public securities exposure that global investors have of China within their portfolios.”

Oppenheimer Funds Inc.’s $39 billion Developing Markets Fund is down 16 percent since August, while BlackRock Inc.’s $34 billion iShares MSCI Emerging Markets ETF has lost 15 percent, in line with the gauge it tracks, according to data compiled by Bloomberg.

Connect Program

To make matters worse, asset managers are also failing to take advantage of last month’s Shanghai-Hong Kong bourse link, which allows foreigners to buy a net 13 billion yuan ($2.1 billion) of onshore shares each day. Daily orders have averaged just a quarter of the allowable limit since the connect program’s inception, in part because mainland stocks now trade at a 14 percent premium to their Hong Kong equivalents, compared to a discount of more than 10 percent as recently as July.

The link “is about familiarity, and it takes time,” Tu said. “It’s also about valuations now. What used to be a very large valuation discount is now non-existent or a significant premium. Long term, people are probably still looking into this exposure, but short term it’s understandable they won’t be in any rush to use the full quota.”

Mainland Buying

The value of China’s domestic stock market has surged by more than $1.1 trillion since August to $4.8 trillion. A Bloomberg gauge of the most-traded Chinese stocks in the U.S. fell 5.8 percent last week, the MSCI Emerging Markets Index lost 4.8 percent, while the Shanghai Composite Index was little changed for the five days.

The Shanghai measure rose 0.5 percent to 2,953.42 at the close, while the Hang Seng China Enterprises Index of mainland shares traded in Hong Kong slid 0.2 percent. The iShares China Large-Cap ETF added 0.2 percent to $39.65 at 10:03 a.m. in New York.

The onshore rally has been a boon for the few U.S.-based exchange-traded funds that can invest directly in the mainland market through government granted quotas.

Deutsche Bank AG’s Deutsche X-trackers Harvest CSI 300 China A-Shares ETF has had to limit new share creations as inflows risk exhausting its 4.32 billion yuan allotment. Investors have bought the maximum allowable under the ETFs limits for eight straight days, Bloomberg data show, helping send assets in the year-old fund to $773 million. The smaller Market Vectors ChinaAMC A-Share ETF has lured a record $47 million over the past month, while the KraneShares Bosera MSCI China A fund has attracted $15 million in December.

Underlying Exposure

Investors need to be aware of how funds seek to gain exposure to China, according to Brian Jacobsen, chief portfolio strategist at Wells Fargo Advantage Funds in Menomonee Falls, Wisconsin.

“You might have the notional exposure, but how are you actually getting it and what exchange is it trading on,” Jacobsen, who helps oversee $235 billion at Wells Fargo Advantage Funds, said by phone on Dec. 12. “It’s always a question of what the underlying exposure is.”

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