By Stephane Loiseau, Managing Director, Head of Cash Equities & Global Execution Services for Asia Pacific, Societe Generale
MSCI’s partial inclusion of China A-shares in its benchmark indices is a catalyst for inflows of global capital, and has prompted traders to rethink their algorithmic strategies.
Recent developments mean that international investors must build their capacity for efficient and seamless trading in China’s onshore equities. Several enhancements to the Stock Connect schemes introduced by the Chinese authorities have eased risk and regulatory concerns, while the well-established Qualified Foreign Institutional Investor (QFII) and Renminbi QFII schemes have familiarised brokerages and buy-side firms with the idiosyncrasies of China’s capital markets.
The catalyst, however, for a surge in expectation and active participation has been the MSCI’s decision in June 2017 to include renminbi-denominated A-shares into its benchmark Emerging Markets and All Country World indices. MSCI added around 230 predominantly blue-chip stocks in a two-step process in June and September this year, following a fourth consultation with global investors since discussions began in 2013.
This year’s five percent partial inclusion, making up approximately 0.73% of the MSCI EM index and 0.1% of the MSCI All Country World Index, is likely to attract about $20 billion of capital into the Chinese equities markets – the third biggest in the world.
Passive investors tracking the benchmark emerging market index had already been required to prepare, but active investors have also been prompted to put systems in place to meet the benchmark requirements, and to benefit from opportunities to earn alpha returns. Moreover, the proliferation of active onshore investors has also encouraged a view of China not only as a liquidity option, but also a trading prospect.
Evidence of this renewed interest is not hard to find. There were about 4000 special segregated accounts (SPSA) before the implementation of the first inclusion by MSCI in June this year; by the beginning of August the number had soared to more than 5800, just before the second inclusion commenced on 1 September.
The MSCI decision was based on positive responses in their consultations with international investors, whose attitude was in turn shaped by improvements to the Stock Connect schemes and to the functioning of the Chinese markets by the Mainland authorities. The Chinese authorities seem clear in their intention to open up their markets to overseas investors and hence re-balance flows, as well as introduce the disciplines of professional institutional fund management in markets that are still around 80% dominated by domestic retail investors.
Indeed, the only significant differences between trading the Chinese market and the US and Japanese markets are some residual operational hurdles which, nevertheless, are navigated by dedicated teams at brokerages, such as Societe Generale. Local skills and professionalism in the Chinese financial industry have also improved in recent years, while a repeat of the destabilising stock suspensions common during the 2015-2016 market turmoil have been forestalled as the authorities pursue a rule-based roadmap to improve market integrity.
Removing operational obstacles
Although international access to the Chinese market was inaugurated as long ago as 2002 with the launch of the QFII programme, regulatory initiatives during the past four years have accelerated. In particular, the launch of Shanghai-Hong Kong Stock Connect in November 2014 and Shenzhen-Hong Kong Stock Connect two years later have spurred global investor interest and activity.
These two-way investment schemes between Hong Kong and the mainland’s two main bourses allow investors to buy Chinese shares through Hong Kong, and vice versa. The daily quota for “northbound” purchases of shares quadrupled to Rmb52 billion ($7.6 billion) from Rmb13 billion on 1 May.
China’s regulators have been quick to address several criticisms of the operational aspects of the Connect schemes, such as trade settlement and custodial idiosyncrasies and they continue to act on recommendations from international investors.
For instance, in June the Shanghai Stock Exchange introduced a consultation to include a closing auction, which is widespread in developed markets and a necessary mechanism for daily valuations of US- and European-managed portfolios. While normally domestic investors are trading intra-day based on market opportunities, many have responded to the recent MSCI trends, by trading towards the close of business too.
Perhaps the greatest problem for international fund managers is the number of days that the market is effectively closed to them. Trading through Stock Connect is conducted with offshore renminbi (CNH) and investors cannot buy CNH on public holidays when the Hong Kong Stock Exchange (HKEX) is closed, and nor can they on the day before the holiday. The problem can be exacerbated by the closures of the exchange on typhoon days.
HKEX could alleviate this obstacle, at least for purchases; sales would be harder to accommodate because the banking system also shutters on these days. In the meantime, this issue is one of the main reasons why many investors also retain their QFII accounts.
Meanwhile, ambiguities about beneficial ownership have been resolved and the T+0 trading cycle is now manageable through SPSAs and augmented by the 24-hour coverage of trade pre-allocation by brokerages.
It is unlikely that QFII will be abandoned any time soon; instead it may be preserved and enhanced as one of the several parallel routes to China’s capital markets. QFII has attractions in addition to its consistent availability: the channel provides entry to a wider variety of instruments, and recent measures have removed the lock-up period for principal and, crucially, allowed onshore currency hedging. Of course, many of the largest investors with exposure to China would like the fungibility between the QFII and Stock Connect schemes, but it is not seen as the highest priority for them or the authorities at least for now.
Societe Generale has been trading Chinese equities since the launch of QFII in 2002, and is fully aware of the markets’ idiosyncrasies and challenges as well as its opportunities.
Traders have had to adapt their algorithms and electronic trading practices to markets dominated by retail investors who sometimes are driven by speculative purpose or indeterminate information, and where daily volume distribution tends to be flat rather than peak at the end of a trading session which is more commonly observed in other regional and global markets.
Societe Generale’s full suite of algorithmic strategies, offered to the firm’s institutional clients and equally suitable for QFII and stock connect, are adjusted to fit the individual volume characteristics of around 3500 individual mainland Chinese stocks, and reflect their particular correlation disparities with the index. In addition to trading volumes, they encapsulate volatility and fair-value calculations.
Sensitivity factors are built into the algorithms that include a wider acceptance of individual stock price movements from its sector index, yet with maximum limits applied, therefore providing a sound level of risk that incorporates a combination of several microfactors. Gathering data is also difficult, but inroads are being made into identifying informative news and trends from social media.
As China continues its effort to open up its capital markets to international investors, the MSCI is likely to decide on full inclusion of Chinese stocks in its benchmark indices which, according to analysts’ estimate, would attract an inflow of $300 billion from international investors. It is therefore essential that trading desks and portfolio managers have the capability to transact effectively as soon as possible.