Should investors follow the China in-crowd?

The cover story for the June issue of Money Observer highlights the meteoric rise in the Chinese stock market. It examines the reasons for the 100%-plus gain and asks whether it can be sustained. Are you concerned that the market is a bubble that is about to burst? Or perhaps you reckon this stonking gain is a precursor of more to come?

Sure, China is beset with financial and economic problems that do not tally with the market's performance. But that's not a problem confined to China. And it is easy to forget that, until a year ago, investing in China had been an underwhelming experience for several years, punctuated by occasional bursts of hope.

It is the recent performance of mainland-listed 'A' shares - now worth an eye-watering $6 trillion (£3.8 trillion) - which has been raising eyebrows. Their rapid ascent has some market-watchers worried, and with good reason. The Shenzhen market is trading on 60 times earnings per share (Shanghai trades on a less lofty 21 times).

Unsustainable bubbles

Andrew Herberts, head of private investment management (UK) at Thomas Miller Investment, says it resembles the internet and telecoms frenzy of 1999 in western markets, and is being fuelled by inexperienced domestic investors investing borrowed money in companies they do not understand.

"Stock market bubbles like China's have usually proved to be unsustainable, but can endure for surprisingly long periods of time," he says.

"This market may run for another few years before the bubble bursts, especially if the country's growth regains momentum, helping to justify current valuations. It is likely that investors in China will be heavily brought back down to earth at some point, but they may well not get burnt just yet."

While such predictions of a disorderly fall in locally traded 'A' shares may not be wide of the mark, another recent development - the opening up of mainland China's capital markets - could put a floor under local market valuations, and may be one of the factors underpinning local investors' confidence.

Indeed some leading emerging market investors believe this opening up to be the single most important financial event in the next decade. Yet global institutional investors are unprepared for the speed of reforms being enacted by the government.

This state of affairs could be about to change. Major index providers such as FTSE Group and MSCI will soon include a large slug of locally traded 'A' shares in their emerging market indices. MSCI will announce the results of its deliberations on 9 June.

Institutional investment vehicles that track (or benchmark against) emerging market indices are expected to be given a few years to build up their 'A' share positions before they enter the indices.

But this new wave of foreign investment in the local market is just a drop in the ocean compared with what is expected to follow. Mark Makepeace, chief executive of FTSE, told the Financial Times that opening up the local market to foreigners means Chinese equities could come to represent 20% of global equity portfolios.

Consider that figure against China's current 2.25% weighting in the MSCI AC (All Country) World index. It is less than Australia at 2.53%; while the US accounts for 52.4%.

Yet China is the world's largest economy and has the second-largest stock market, with a level of economic dynamism and favourable demographics that simply are not reflected in global equity index benchmarks.

A piece of the action

Until recently it was difficult for private investors in the UK to participate in the local 'A' share market, but they might wish to get a toehold via an exchange traded fund (ETF), if only to buy on another of the dips that have punctuated the 'A' market's ascent.

Two options include recently launched iShares MSCI China A Ucits and ETFS-E Fund MSCI China A GO Ucits, which was launched in May 2014.

For passive investing vehicles that track similar indices, the disparity between local market ETFs such as the ETFS-E Fund and other China ETFs that invest via Hong Kong is nothing short of extraordinary, as the chart shows.

The ETFS-E ETF has gained 129% over the year compared with 49% for Db XTrackers MSCI China Index Ucits, which has most of its holdings in Hong Kong-listed 'H' shares, 'P' shares and "Red Chips".

It is interesting to note, too, that the concentration of holdings in the top 10 of the 'A' shares ETF is far lower than that of its Hong Kong-invested counterpart. So despite the high degree of froth in the 'A' shares market, the 'A' shares ETF is providing exposure to a wider range of mainland sectors and companies.

The Chinese have a reputation for fearless gambling and speculating. Local Chinese investors who have pushed the mainland 'A' market to these giddy heights may take some money off the table at this stage in the game.

But they might also keep a decent slug of chips in play, safe in the knowledge that the rest of the world is going to be playing catch-up as China's capital markets open up.

Perhaps a small investment in a China 'A' shares ETF, alongside more familiar and actively managed China-focused funds, will turn out to be more of an educated gamble than it first appears.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.