Vanguard Moves First to Add China A-Shares

Patty Oey: The Vanguard Emerging Markets Index fund, which includes the ETF VWO, is by far the largest emerging-markets fund, with over $65 billion in assets. In early June, Vanguard announced that it will be making a change to this fund. Starting later this year, it will begin to track a new index that includes onshore China A-shares.

There has been a lot of volatility in the onshore China A-share market. After a 150% rally in China A-shares in the 12 months up to mid-June 2015, China A-shares tumbled about 30% in the subsequent three-week period. The rally was driven by looser monetary policy in China and a strong pickup in domestic investor trading activity ahead of anticipated large foreign inflows, such as this Vanguard fund, as China liberalizes its capital markets. Trading activity was further fueled by a surge in government-endorsed margin lending by local brokerages to domestic Chinese retail investors.

When markets began to take a sharp turn downward a few weeks ago, the Chinese government took unprecedented and aggressive steps to stem the slide. These include buying blue chips outright, loosening margin-trading requirements, banning large shareholders and company executives from selling their shares for six months, and allowing around 1,500 companies to suspend trading of their shares. [The transcript has been corrected to reflect the accurate number of companies that suspended trading.] It is fair to say that Chinese government intervention in the markets continues to be a significant source of uncertainty, as well as volatility, in the Chinese equity market.

Other emerging-markets index funds and ETFs currently do not hold China A-shares. However, they are expected to add them in the future, as index providers MSCI and FTSE have China A-shares on their watchlists for inclusion in their equity indexes. Using current market values, these emerging-markets index funds could eventually have a China allocation of 30% to 40%, which would include both China A-shares and Hong Kong-listed Chinese companies.

If a large allocation in Chinese equities is a concern, then a better option for emerging-markets exposure 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.