Adding China A-shares to the index: What it means for fundholders

Vanguard plans to gradually add the new securities (and trim the weightings in existing holdings) over the course of a year, starting in late 2015. By taking a gradual approach, Vanguard hopes to minimize front-running and transaction costs. This will be the second major change Vanguard has made to this fund over the past few years. Vanguard removed South Korean securities (which used to account for about 13% of the portfolio) from this fund over a six-month period in 2013 as a result of changing the fund's bogy from the MSCI Emerging Markets Index (MSCI classifies South Korea as an emerging market) to the FTSE Emerging Index (FTSE classifies South Korea as a developed market).

What are China A-shares?

China A-shares are companies listed onshore either on the Shanghai or Shenzhen stock exchanges. Historically, foreigners had very limited access to these shares because China has a "mostly closed" capital account, whereby investors, as well as companies and banks, could not move money into and out of the country except in accordance with strict rules. China has been gradually opening up its market, and, currently, foreign institutional investors can gain access to China's onshore market via a Qualified Foreign Institutional Investor or Renminbi Qualified Foreign Institutional Investor license. License holders have to go through an approval process and then are granted a quota as to how much they can invest in Chinese securities. Foreign investors can also purchase certain Shanghai-listed stocks on the Hong Kong Stock Exchange.

Currently, Vanguard Emerging Markets Stock Index has a 29% allocation to Chinese equities composed of Chinese firms listed in Hong Kong. After the index change is completed in 2016, this Vanguard fund will hold both Hong Kong-listed Chinese firms (which would account for about 26% of the portfolio), as well as onshore-listed firms (which would account for about 6%), for a total China allocation of 32%. These estimates are based on current prices--this allocation could be slightly larger or smaller, depending on how Chinese stocks perform relative to other emerging markets in the interim.

There are a number of companies that are listed both in Hong Kong and in China. Most of them operate in the financial services sector. Generally speaking, there are more mega-caps listed in Hong Kong and more large caps listed onshore. There is more breadth onshore, with about 520 large-cap listings, compared with 140 large-cap listings in Hong Kong. The onshore market is also growing more rapidly. There were about 100 IPOs in the first four months of 2015, compared with 48 over the same four months in 2014.

How big is the Chinese equity market?

Currently, the free float-adjusted market capitalization of China A-shares is US$1.4 trillion. This, combined with the US$1-trillion market capitalization of Hong Kong-listed Chinese firms, brings China's total market capitalization to US$2.4 trillion. As a point of reference, the market capitalization of U.S. equities is $20 trillion and the current market capitalization of the FTSE Emerging Index is US$3.6 trillion. (These market-capitalization figures include large caps and mid-caps and are calculated by FTSE).

The total market capitalization of China A-shares is not going to be added to the Vanguard mutual fund and ETF. If that were the case, China A-shares would account for 27% of the index, and total China exposure (including Hong Kong listings) would account for 48%. FTSE has capped the exposure of China A-shares in its index to reflect the total amount of quota available to foreign investors. China has said that it will continue to raise the quota limit, and FTSE plans to ratchet up the index's China A-share allocation on a quarterly basis as the quota expands.

Haven't China A-shares rallied recently?

Over the past 12 months, the CSI 300 Index (the A-share benchmark) has returned around 130%. The China onshore market is dominated by retail investors, who generally take a more short-term, momentum-oriented approach to investing. The anticipation of foreign fund flows into China's equity markets, combined with recently loosened margin trading requirements, have helped drive this recent bull run.

Should I stay or should I go?

For investors with a classic 60/40 stock/bond portfolio, emerging-markets stocks will typically account for about 5% of their portfolio. So even if Chinese stocks ultimately accounted for 40% of the Vanguard fund's portfolio, it would only account for about 2% of the overall portfolio--assuming the Vanguard fund was the one and only emerging-markets fund it contained. Some investors may feel that it may not be worth the effort (or the realized capital gains) to switch funds.

Investors who hold other emerging-markets index funds are likely to see China A-shares added to their portfolios in the coming years. MSCI's latest review indicates that it is only a matter of time before the benchmark provider follows Vanguard's lead.

If you want to avoid index funds for this reason, then a better option would be actively managed funds. More specifically, you should focus on funds run by managers with a benchmark-agnostic approach--in other words, managers who are not afraid to run portfolios that look different from their benchmark index.