Get ready to own more of China!

Traders work on the floor of the New York Stock Exchange.
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On Tuesday, the world's largest indexing firm, MSCI, will rule whether shares in mainland China should be included in the firm's global indexing scheme, which is used by fund managers and ETF providers the world over.

It could mean billions of dollars would come out of other emerging market countries like Brazil and South Africa and flow into mainland China.

There are three main classifications of Chinese stocks: 1) A-shares, which are mainland China stocks, 2) H-shares, which are Chinese companies that trade on the Hong Kong exchange, and 3) N-shares, Chinese companies that list on the U.S. markets.

While H-shares and N-shares are widely available to outside investors, the A-shares are not. But that is changing.

Why is this a big deal? It's simple: indexers rule the world. Many investors are increasingly investing through indices, most of which are used in the 1,600 ETFs that are traded every day in the U.S.

Adding more China stocks to indexes essentially forces investors to hold more exposure to China.

There's a larger political and economic issue at stake: China wants to become a bigger part of global trade. A key component of that is to become a bigger part of the global stock trading market.

By all accounts, China is slowly accomplishing that goal. Mainland China (the Shenzen and Shanghai exchanges) has the second-largest stock market by market capitalization, while Hong Kong is third:

Stock market capitalization by country (in trillions)
U.S. $24.8
China 9.7
Hong Kong 5.2
Japan 5.0
UK 3.8
France 2.1
Canada 2.0
Germany 1.9
Source: Bloomberg

But China has had problems getting to "the next level." The problems are twofold:

1) China itself has restricted ownership of A-shares by foreigners. However, the government has begun allowing more access to the mainland market. Last November, for example, a trading link was established between the Hong-Kong Exchange and the Shanghai Exchange that allowed foreign investors to buy mainland shares through registered broker dealers, though this, too, is subject to a quota.

2) Indexers—including MSCI and its main competitor, FTSE—have until recently considered the A-shares ineligible for inclusion in their indexes because of those restrictions and, to a lesser extent, over concern about government control of some of the largest enterprises.

The key is that MSCI must be comfortable that there are enough A- shares available to foreign investors to replicate their indices, and that may be a problem. After all, they can't reweight the indices and then discover that the people using the indices (ETFs, for example) can't buy enough stock to cover demand.

One way to deal with this issue is a gradual roll out of, say 5 percent of the listings by market weight initially, then adding more in the coming years. They could, for example, just include a few large companies initially.

One thing's for sure: there is clearly momentum to bring mainland China into the international fold.

Just a couple weeks ago, MSCI's competitor, FTSE, added China A-shares to its core benchmarks.

This is getting a bit more publicity than usual because of the enormous out-performance of China's mainland market this year.

China markets this year
Shanghai, up 58%
Shenzhen, up 112%

Those are eye-popping numbers, and we have seen much higher levels of money flowing into the few ETFs that have access to China A-shares, including the X-trackers CSI 300 A-Shares ETF (ASHR), which launched in 2013.

Let's look at the MSCI Emerging Markets Index, which is the index used for the largest emerging market ETF, the iShares Emerging Market ETF (EEM).

There's over $1.5 trillion indexed to this alone.

Right now, about 23 percent is pegged to China, all represented by stocks that are listed in Hong Kong.

MSCI Emerging Markets Index (weighting)
China 23%
South Korea 14%
Taiwan 13%
South Africa 7%
India 7%
Brazil 5%
Mexico 5%
Russia 4%
Other 20%

However, the market for mainland China stocks is far larger than Hong Kong--adding even modest amounts of mainland shares could push China's percentage over 30 percent. Some estimate that if China was fully weighted in the index, it could represent 60 percent of the entire EEM!

Which would probably be fine with China.

The next step would be to include more of China in broader, global indices. For example, the MSCI All Countries World Index has a minuscule weighting to China:

MSCI All Countries World Index (weighting)
U.S. 50%
Japan 8%
UK 6%
Germany 3%
China 2%

Note the disparity: the U.S. has 50 percent of the weighting, and China has only 2 percent, despite the fact that China is roughly 15 percent of global GDP.

One final point: China is also set to announce an additional Shenzhen-Hong Kong stock link to complement the existing Shanghai-Hong Kong link. If that happens, it will make it even easier to own mainland China shares, and MSCI could accelerate the integration of China into the global markets.

Get ready to own more of China!