Nearly six years ago, when Big Tree Capital launched its emerging markets-focused ETF EMQQ, China had already embarked on bold measures to open its financial markets, and its founder, Kevin Carter, thought US-China relations could only improve in the long run.
“I was completely wrong about that,” Mr Carter said, pointing out relations between the two countries recently have gone on to hit what he described as the worst he had observed since he started his career in passive investing.
Yet despite the US-China trade war that has dominated headlines, and a deteriorating political climate made worse by the pandemic, Big Tree’s EM ETF has done quite well, with assets under management rising nearly 60 per cent this year to more than $115m.
That unexpectedly strong performance could convince investors to believe buying Chinese equities might continue to pay off handsomely, even as US-China tensions worsen. Yet hostility between Washington and Beijing is raising questions about how sustainable that trend really is. Troubling signs have emerged since the beginning of the year — the US Senate passed legislation in May that could force Chinese companies to delist from Wall Street, and only last month the US State Department warned US colleges they should divest from Chinese stocks, even those held passively.
Things looked far rosier three years ago. MSCI, the provider of the most widely tracked emerging market index, decided to include domestically listed Chinese A-shares in June 2017, just a month after Mr Trump and his Chinese counterpart President Xi Jinping reached a US-China trade deal, assuaging concerns over an imminent trade war.
MSCI continued to increase the weighting of A-shares until they accounted for about 4 per cent of the influential index by the end of 2019.
There has already been a significant effect on investment. FT calculations based on Bloomberg data show that since MSCI first announced plans to include Chinese domestically listed A-shares, roughly $875bn in foreign investment has flowed into Chinese equities through stock connect programmes linking Hong Kong with onshore bourses in Shanghai and Shenzhen.
Thomas Gatley, an analyst at Beijing-based Gavekal Dragonomics, a consultancy, said inflows through the connect programmes have lined up “almost perfectly” with MSCI’s weightings, suggesting the lion’s share of inflows have come from passive funds.
But progress appears to have slowed. By the end of 2019, MSCI had taken a harder line on conditions for a bigger presence of Chinese equities, demanding greater access to hedging tools and smoother settlement of trades.
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Some observers think even if these and other concerns were addressed it could be years before MSCI holds further consultations on greater weighting for Chinese stocks. “Even if we see the conditions they’ve laid out for the next stage of inclusion met, they’re probably going to want to take a little breather,” Mr Gatley said of MSCI.
The current political climate in the US makes it risky for any large US institution to raise their allocation to A-shares, even for pension funds in states that reliably vote against Mr Trump.
“Talking to Democrat-run states — places where they’re not necessarily facing immediate threat of legislative action — they feel extra cautious about even saying China in their investment strategy,” Mr Gatley said.
So far the Trump administration’s most concrete step towards limiting passive investment in China has been to order the main federal government pension fund not to go ahead with plans to invest its portfolio in Chinese companies. The Federal Retirement Thrift Investment Board, an agency that manages almost $600bn in its “Thrift Savings Plan”, had been preparing to shift to MSCI’s All Country World ex-US Investable Market index to provide the roughly 5.5m federal employees who invest in the fund with more competitive returns.
Analysts pointed out, however, there were limits to how much an anti-China US administration could influence investors’ decisions on whether to back Chinese companies. Even if proposals to force greater disclosure on US-listed companies were passed and Chinese companies delisted from US exchanges, there would be nothing to stop investors from buying shares in the same company listed in Hong Kong, Shanghai or Shenzhen.
Travis Lundy, an analyst at Quiddity Advisors who publishes on research platform Smartkarma, said index providers were likely to kick the can down the road by providing “ex-China” EM indices and ETFs, of which there are just a handful.
If the White House really wanted to stop US investors from investing in Chinese companies, he added, “the only way you can really do that is by making it illegal to hold Chinese currency or Chinese-currency assets”.
If that were to happen, relations between the two largest economies would have deteriorated to the extent that losses could go well beyond financial markets. “It’s not something to undertake lightly,” Mr Lundy said.