MSCI's big decision on adding mainland China stocks to emerging markets index

Tomorrow afternoon MSCI, one of the world's largest index providers, will decide whether to include a selection of China's mainland stock market into its MSCI Indexes, which underpin some of the largest ETFs in the world, including the iShares MSCI Emerging Market ETF (EEM) and the MSCI ACWI Index ETF (ACWI).

It's a big decision: As I've said many times, indexers now rule the world. MSCI has more than $10 trillion of active and passive assets benchmarked against it, with emerging markets alone accounting for $2 trillion. Hong Kong stocks are already included, but including mainland China would increase the weighting of China stocks in the Emerging Market index from roughly 26 percent to over 40 percent with full inclusion. Acceptance of mainland China would mark a major move forward for China's domestic markets and oblige funds all over the world to invest billions in mainland China.

Inclusion is not a foregone conclusion. MSCI has passed on including mainland China in the last three years, even as its competitor, FTSE (owned by the London Stock Exchange), does include mainland China stocks.

Major issues included too many trading halts and concerns over quotas, specifically whether Chinese authorities would put limitations over how much could be invested or withdrawn.

But the arguments "for" inclusion are getting louder. The main argument is the sheer size of the mainland China market: north of $6 trillion in the combined Shenzhen and Shanghai indices. That's about 10 percent of the market capitalization of the entire global equity market (the U.S. market cap is roughly $28 trillion). Excluding 10 percent of the global equity market does not make sense, the argument goes. Right now MSCI's broadest index — the MSCI All-Country World Index — assigns China a roughly 3 percent weighting. But China's actual total weighting is closer to 17 percent.

And Chinese authorities have addressed some concerns raised in prior years. For example, there are new rules that limits under what circumstances and for how long Chinese companies can halt trading, a major issue last year when hundreds simply suspended trading during a drop in the market early in 2016.

China has also instituted the Shanghai–Hong Kong Stock Connect and the Shenzhen–Hong Kong Stock Connect, which connects both mainland exchanges with the Hong Kong Stock Exchanges and which enables investors to trade shares listed on each other's markets using local brokers and clearinghouses. The Connect has a daily quota (just over $2 billion a day can go in or out on each exchange).

These changes may be sufficient to get the deal through. BlackRock, the world's biggest asset manager, has backed inclusion of domestic Chinese shares this year.

Part of this may be strategic. BlackRock's rival, Vanguard, which uses an index provided by FTSE, an MSCI competitor, already includes A-shares. It's taken some time, but the world is coming around to our point of view — that China ultimately will become an asset class by itself. Investors will need China.

What does this mean for investors? It means if you own international indexes through ETFs, the chances are you will be owning much more China stocks in the next few years.

Upon full inclusion, China's weight within MSCI Emerging Markets will rise from 26 percent to about 43 percent, a gain of about 17 percent. Seventeen percent of $2 trillion is a big number, which is why the inclusion will be implemented over several years. MSCI is using their own index, the MSCI China A International Index, which is a market-cap weighted index consisting of 446 companies from the Shanghai and Shenzhen indices. To avoid a rush of buying, the initial inclusion will rise by only 1 percent of the index and will initially cover only 169 stocks and then gradually expand to include the other names over the next several years.

The iShares Emerging Markets ETF (EEM) is the biggest of all the ETFs benchmarked to the MSCI Emerging Markets Index. But if you want more direct exposure to mainland China stocks, the KraneShares MSCI China A Shares ETF (KBA) was created specifically to track the index MSCI is using.

That makes KraneShares CIO Brendan Ahern very happy. "We saw this opening-up taking place several years ago," he told me. "It's taken some time, but the world is coming around to our point of view — that China ultimately will become an asset class by itself. Investors will need China."

What's the next frontier? China's bond market is the third-largest bond market in the world, after the United States and Japan, with assets north of $7 trillion. Their bond market is not in any indices, either.

What happens when the third-largest bond market goes from zero percent weighting to a significant percentage?