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Indexes open China to millions more

Investors watch the eclectic monitor at a stock exchange in China on June 1. Photo: Zuma Press

Global investors are soon going to get a taste of stock trading, China-style.

With the major stock-index providers adding or likely adding stocks that trade on China’s domestic markets, millions of foreign investors will own a piece of a market that has some of the highest valuations and volatility in the world.

It is also a market heavily guided by the Chinese government and one that has few protections for investors. The market’s recent performance has been driven by small, fast-trading investors, many with newly opened brokerage accounts, using borrowed cash to juice their returns.

On Tuesday, index provider MSCI Inc. will decide whether to include China’s domestic markets in its widely followed emerging-market and global indexes. Already, rival index provider FTSE Group, owned by the London Stock Exchange Group PLC, has inaugurated transitional indexes for emerging markets to include Chinese A-shares, and another competitor, S&P Dow Jones Indices, said it would likely add the shares to its indexes in September. S&P Dow Jones is a joint venture between McGraw Hill Financial Inc. and CME Group Inc, with a 2.6% stake held by Dow Jones, a unit of News Corp, publisher of The Wall Street Journal.

MSCI could decide to break away from its competitors and reject China, although in the highly competitive stock-index market that would be a big bet, especially if Chinese shares continue to soar. And the prospect of pouring cash into China’s market right now could cause some overseas investors to balk and consciously reduce their exposure to indexes that include China.

The big risk is that foreign investors buy into these markets just before they tumble.

“[China] is liberalizing and knocking down different pillars in terms of how easy it is for foreigners to get in,” said Nicholas Teo, market analyst at CMC Markets in Singapore. “The flip side is we may be entering the game at its most volatile period.”

Billions of dollars of passively run index funds track these benchmarks, but a far larger amount of cash is run by active managers who are judged on whether they beat the indexes. If China shares soar, they are under intense pressure to buy into the rally, no matter what the valuation, fearing their performance will lag behind.

The Shanghai market, China’s largest, is up 53% this year through Friday and more than 140% in the past 12 months, while the smaller and more volatile Shenzhen market is up 116% this year and nearly 190% in the past 12 months. Nearly 60% of 2,733 domestic stocks have more than doubled this year, according to database WIND.

The Shenzhen market is considered even more risky, with its smaller startup firms now trading at record levels and price/earnings ratios averaging 130 times trailing earnings.

The Shanghai market has lost or gained more than 3% in a single session nearly a dozen times this year. Most recently, shares tumbled 6.5% on May 28. Thursday morning, they sank more than 5% before rebounding to close higher. On Friday, Shanghai’s market closed above the 5000 level for the first time in more than seven years.

China’s market faces a new challenge this week after the country’s securities regulator said late Friday it would revise rules on margin trading and short selling. While the regulator didn’t say when the changes would occur, any limitations on margin trading, which has exploded in China and been a big driver of the rally, could push shares down.

The risk of volatile stocks being added to major indexes was made clear when China’s largest solar power company, Hanergy Thin Film Power Group Ltd., soared nearly sixfold in a year, pushing up its weighting in some China and solar-focused benchmarks. The stock fell by nearly half in just moments in late May on the Hong Kong stock exchange.

The investors tracking indexes eventually lost out. The $360 million Guggenheim Solar ETF, which had 12% of its portfolio in Hanergy stock, fell by 7.8% the day after Hanergy’s stock plunged in Hong Kong. Van Eck Global’s Market Vectors Solar Energy ETF, in which Hanergy accounted for 8.2%, fell by nearly 7%.

Most index funds are much more diversified than these, and other funds that owned Hanergy shares suffered much smaller losses.

But index funds by their nature hold bigger stakes in stocks that have performed well recently, often meaning they are expensive. Standard & Poor’s famously added Yahoo Inc. to its S&P 500 stock index near the peak of the tech bubble in 1999, and the shares subsequently fell 96%.

Many of the 582 Chinese stocks that benchmark provider FTSE recently added to its new emerging-market index have high valuations. Among them is electric-car and battery maker BYD Co., which trades at a price/earnings ratio of 464.

The MSCI Emerging Markets Index alone is tracked by $1.5 trillion worth of assets, 16% of which comes from passive funds. Analysts expect MSCI to include Chinese domestic stocks, or A shares, in coming years, even if it doesn’t decide to do so on Tuesday.

“We have more than 50 products indexed to MSCI benchmarks, so we put a lot of trust in MSCI’s designs to mitigate risks,” said François Millet, product manager for ETFs and indexing at Société Générale’s Lyxor Asset Management, which runs some of world’s largest emerging-market ETFs.

Warnings by regulators about particular stocks haven’t always deterred index providers. Hong Kong’s Securities and Futures Commission warned investors in March to beware of trading Hong Kong-listed Goldin Financial Holdings Ltd.—a wine-trading, financial-services and property-development conglomerate—because its ownership was concentrated among a few dozen shareholders. Its stock increased fivefold during the year before the SFC’s alert, but FTSE added it to its benchmark for large-cap Hong Kong stocks. Two months later, the stock shed almost half its value in a single trading session. FTSE declined to comment on individual stocks.

MSCI added Goldin Properties Holdings Ltd., part of the same corporate family as Goldin Financial, to its MSCI China Index, days after its shares also nose-dived on May 21.

MSCI’s said it reviews its indexes regularly. But, “market capitalization fluctuations after the index review announcement date typically wouldn’t result in the reversion of an already announced decision,” it said in a written response.

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