China loves the MSCI scramble, hates manipulators

By Shuli Ren / BLOOMBERG

The wait is almost over. But as MSCI Inc opens the door to China’s stock markets, foreign fund managers need to be careful they’re not labelled manipulators by Beijing, again.

On June 1, the firm will add more than 200 China A shares to the benchmark MSCI Emerging Markets Index.

Inclusion could attract anywhere between US$10 billion (RM40 billion) and US$35 billion of inflows, by recent estimates. Smartkarma analyst Travis Lundy, for one, is staying at the bottom of the range.

As fund managers sift through stock weightings announced this morning, there’s bound to be arbitrage on the big day.

If a mutual fund plans to buy US$200 million shares of new entrants, its manager might stagger US$120 million of orders several days before the event, then, say, US$40 million the morning of June 1 and US$40 million just before the closing bell.

That last trade will tend to push the price up — funds’ net asset values are based on closing prices, and a small capital gain could help offset management costs.

It’s just as likely that hedge funds will buy well ahead of the event, hoping passive funds will pour billions into those shares at much higher prices on June 1.

Some of this manoeuvring may already have happened. In May, foreigners bought a net US$6.4 billion, the second-highest monthly total, through the stock connect pipelines with Hong Kong.

More than US$3 billion went into the financials, materials and industrials sectors, those most under-represented in global funds. As it turned out, MSCI’s favourites were consumer staples, from liquor makers Kweichow Moutai Co and Wuliangye Yibin Co to milk producer Inner Mongolia Yili Industrial Group Co.

Great Expectations
Investors reckoned MSCI would include more companies in consumer staples, industrials and materials. It turns out consumer staples were the biggest winners.

These are fairly standard arbitrage strategies. But Beijing may not be amused. Just three years ago China halted stock index futures trading and blamed foreign funds for “malicious” short selling.

The market regulator is particularly sensitive about closing prices just now.

Beijing is encouraging funds to help shift the wealth-management industry to a Western model, where investors understand returns are compensation for risk.

But this early in the game, there are complications. Because mutual funds typically list only their top 10 holdings, public investors tend to pay disproportionate attention to those stocks.

As a result, a fund’s market value can deviate substantially from its net asset value. This gives managers an incentive to manipulate closing prices of these few stocks, possibly repeating a tactic Hanergy Thin Film Power Group Ltd used with its own shares in 2015.

A case in point: Aegon-Industrial Heyi Flexible Allocation Regular Mixed Equity Fund, which had 31.8 billion yuan (RM19.08 billion) of assets under management at the end of March, was caught up in last month’s ZTE Corp scandal.

The fund had its April 23 debut at 11.4% below net asset value, even though only 1.48% of the fund was held in ZTE.

ZTE Slump
Aegon-Industrial’s mutual fund, which managed 31.8 billion yuan as of March, listed at only 89 cents on the dollar because ZTE is a top 10 holding.

Finally, don’t ignore what sometimes looks like the curse of MSCI inclusion. New members of the emerging-markets index lost an average 11% in the three months after inclusion, according to Goldman Sachs Group Inc estimates.

A painful recent example was Pakistan, whose shares dropped 20% after entering the index in June 2017.

Asset managers from UBS Group AG to Vanguard Group Inc are vying for a place in China’s US$2 trillion investment industry.

But given the emotional politics around MSCI inclusion, do you want to buy high now and risk Beijing’s wrath? Perhaps wait for the dust to settle.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.