Chinese stocks are about to become a bigger part of the global investor's portfolio. And there is more coming.
China is a huge part of the global economy, but a good part of China's stock market is not represented on any of the global indices. Starting Dec. 1, MSCI, one of the leading index providers in the world, will include all 14 U.S.-listed China stocks in its indices, including Alibaba and Baidu.
Believe it or not, these big Chinese companies like Alibaba, the biggest e-commerce retailer by far, and competitor Baidu, have not been represented in global indices.
That's going to change.
MSCI will include 14 companies: Alibaba, Baidu, Ctrip, JD.com, Netease, New Oriental Education, Qihoo, Qunar Cayman Islands, Soufun Holdings, Tal Education, Vipshop Holdings, Youku Tudou, YY, and 58.com.
Why is this important? MSCI's indices are used all over the world, in index funds, ETFs, even by active managers, so when there is a big change in the composition of the indices, it gets attention because a lot of money is going to be moved around.
How much money? There's over $9 trillion indexed to MSCI's indexes, including the All-Country World Index which is designed to capture the performance of a vast swath of stocks in almost 50 countries, and smaller slices of the world's stock markets like Emerging Markets, and Europe, Africa and Far East.
For this specific trade, Goldman Sachs estimates there may need to be as much as $94 billion that needs to be bought. To break up that impact, MSCI is splitting the inclusion of the stocks in two: half will go in December 1, the other half on June 1.
Every passive asset manager that is pegged to any MSCI index that owns China — the ETFs, the index funds — will have to own these stocks.
In the Emerging Markets Index, China's weighting will go from 25 percent of the index to 29 percent.
Even active managers will have to consider owning all or part of the 14 stocks. Active managers theoretically pick stocks on their own. Their job is to outperform the indexes that they use as benchmarks. Now that the universe that is used in the benchmarks is growing, even an active manager is going to have to consider which of these stocks he is going to pick that will outperform.
There is a larger issue playing out here. The debate over active versus passive management — stock picking versus indexing — is mostly over.
The indexers have won. Therefore, whoever controls the composition of the biggest indexes controls the investment habits of a very large part of the world's investors.
So when every index that includes China gets reweighted, investors pay attention.
One other point: the sector weightings for China will change. There will be more Technology, less old-school Financials and Industrials. These updated indices will more accurately reflect the modern, growth-oriented China, one its leaders want so badly to project.
Technology, for example, will go from a weighting of 14 percent to 27 percent within the MSCI China Index, according to an analysis done by Kraneshares, an ETF provider that operates several China ETFs.
Financials will go from a weighting of 42 percent down to 34 percent.
This is only the start of it. 2016 may see a tidal wave of Chinese stocks entering the global indices. The entire China A shares market — Chinese companies that list on the Shanghai Stock Exchange and the Shenzhen Stock Exchange — are not included in world indices.
Think about that. The third biggest stock exchange in the world by market capitalization (Shanghai) and the fifth largest (Shenzhen) are both excluded from world indices. It's crazy.
Right now, Chinese shares are represented in global indices only through Hong Kong.
The Shenzhen-Hong Kong connect, which will link the Shenzhen and Hong Kong exchanges and make it possible for foreign investors to invest directly in companies listed on the Shenzhen, will likely happen in the first quarter. The Shanghai-Hong Kong connect has been active for over a year.
Getting the Shenzhen-Hong Kong link going will be one of the final pieces to allow MSCI to include the entire Chinese mainland market in their indices.
When that happens, it will be a real earthquake in these indices. Adding U.S.-listed Chinese stocks will increase China's weighting in the MSCI Emerging Markets Index from 25 percent to 29 percent. Adding the "A" shares will likely increase China's weighting in the Emerging Markets Index from roughly 29 percent to 40 percent. That is huge.