At its May 2016 index review, MSCI completed the addition of a number of U.S.-listed Chinese companies into its MSCI Global Investable Market Indexes. As a result, China's weighting has increased in a number of key indexes, and its role in global portfolios has also been amplified. This has various implications for portfolio managers and investors.
China's progressive financial market liberalisation has spurred numerous IPOs and the success of many Chinese companies such as Tencent (TCEHY), which has been reflected in their gigantic market capitalizations.
This has had a significant impact on the evolution of China's weighting in the MSCI Emerging Markets Index. A decade ago, the index was dominated by Taiwan and South Korea, and China accounted for a meagre 3.69%. Fast forward to June 30, 2016, and China has become the largest country weighting at 25.79%.
China set to grab even more of the market
The story does not end there. China will continue to gain global importance as it improves accessibility to its onshore A-share market, one that offers better liquidity and a more diversified opportunity set than the Hong Kong stock market, which is currently the most commonly used avenue to get Chinese exposure. Many asset managers believe it is only a matter of time before they can include A-shares and have accordingly been beefing up their A-share research capabilities or even managing their portfolios against a custom benchmark that includes A-shares.
According to an MSCI consultation paper, a potential full inclusion of A-shares can raise China's weighting in the MSCI Emerging Markets Index to almost 40%. That said, this will require, among other things, China's full liberalisation of its capital mobility restrictions, and it will likely take a long time to materialise.
How the Chinese stock market is diversifying
The inclusion of Chinese companies listed on U.S. exchanges (American Depositary Receipts, or ADRs) into the MSCI indexes has undoubtedly helped to better reflect the Chinese investment universe and provide more-relevant performance benchmarks for portfolio managers and investors alike.
Prior to the ADR inclusions, the Chinese exposure of various indexes predominantly came from the "old economy" -- traditional sectors such as banks, energy and telecom services, where many firms are state-owned. For instance, financial services, which comprises banks, insurers and property developers, was by far the most prominent sector and accounted for about 40% of the MSCI China Index.
MSCI added 14 ADRs to its indexes as a result of the index review. Many of these new constituents are privately owned "new economy" companies, particularly Internet-related companies. As a result, the MSCI China Index's information technology exposure dramatically increased from 17% to 31%.
Notably, 
Alibaba (BABA) and Baidu (BIDU) became index giants and accounted for 8.15% and 4.64% of the index, respectively. The index's consumer discretionary exposure also doubled from 4% to 8%. On the flip side, the once-overriding financial sector now shares its top position with the IT sector at around 30%.
We think that these changes better align the index with the growth drivers of the Chinese economy, with an increased representation of the in-demand service industries, such as the IT and consumer sectors. These sectors are arguably more directly exposed to the Chinese domestic-consumption story, a popular long-term investment theme as China looks to transition away from an investment-led economy, than some of the traditional sectors such as oil and gas.
From a quality perspective, the substantial increase in the more privately owned new-economy sector has indirectly diluted the exposure of state-owned-enterprise-heavy old-economy sectors. This shift in ownership dynamics presents a differentiated opportunity set for portfolio managers, one that focuses on return-on-equity potential and the alignment of interests between management and shareholders.
How active fund managers may benefit
Investors in benchmark-aware strategies -- funds with relatively tight tracking-error budgets and not much leeway to deviate from the index -- can expect increased exposure to the added index constituents, whether their portfolio managers believe those names have strong investment merits or not. For example, a few benchmark-conscious portfolio managers invested in Baidu despite their belief that the company has over-monetized its search results. Nonetheless, they bought the name to manage benchmark-relative risks and expressed their dislike through an underweight position.
On the other hand, some have had the foresight to invest in select U.S-listed Chinese companies prior to the inclusion exercise and captured considerable upside before the huge buy-in from the market. The Chinese investment universe has continued to expand and evolve, and China is becoming an increasingly important part of global investors' portfolios.
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