After a tremendous yearlong rally during which onshore China A-share markets skyrocketed some 150%, these stocks have hit an air pocket, sliding around 30% during the last few weeks.
The Chinese government has taken unprecedented and aggressive steps to stem the slide, including 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.
Whether these moves will shore up confidence among China A-share investors, who are primarily domestic retail investors, remains to be seen. Ironically, one of the drivers of last year's rally was Chinese investors' anticipation of large foreign fund flows into the onshore market in the coming years as China liberalizes its financial markets. Given the recent volatility and heavy-handed response by the Chinese government, foreign investors may remain on the sidelines for the time being. Without this foreign flow "catalyst," domestic investors may remain wary. Suffice it to say that there is a great degree of uncertainty lingering over the Chinese equity market.
Most emerging-markets fund managers are evaluating China A-shares (given the size and importance of the Chinese economy) but have not yet invested in China's onshore market. So investors holding emerging-markets funds have not been directly exposed to this recent volatility. For China exposure, emerging-markets funds primarily hold offshore Hong Kong-listed Chinese companies. While those shares have experienced some volatility, price movements have not been as dramatic as they have been in the onshore A-share market.
It's also important to place these events in their appropriate context. Investors with a 60/40 stock/bond portfolio of broadly diversified index funds will have about a 5% allocation to emerging-markets stocks. This means that Chinese stocks, on average, will account for about 1% of the entire portfolio. So while there have been plenty of headlines about the dramatic moves in the onshore Chinese equity markets, these events have had a minimal impact on the average investor's portfolio.
Investing in China
Investing in China can be confusing. Currently, most offshore investors get exposure to Chinese companies via shares listed in Hong Kong. However, a handful of ETFs invest in the onshore Shanghai and Shenzhen markets, where there is more breadth--the MSCI China A Index (which captures about 85% of the onshore A-share investment universe) is composed of 577 constituents, whereas the MSCI China Index (which captures about 85% of the Hong Kong-listed China equity universe) has 145. That said, firms with a Hong Kong listing typically are larger, more established companies, relative to companies listed onshore. But some Chinese companies have dual onshore and offshore listings, and these dual-listed companies comprise about 25% of the MSCI China A Index and 50% of the MSCI China Index. As for top sector weightings, for the MSCI China A Index, it is financials (31%), industrials (21%) and consumer discretionary (11%). For the MSCI China Index, the largest sector weightings are financials (43%), technology (13%) and telecoms (10%). (This ETF tracks the market-cap-weighted CSI 300 Index, which is very similar to the MSCI China A Index).
As for risk, during the past three years, the MSCI China A Index's annualized standard deviation of returns was 29%, whereas the MSCI China Index's was 17%. China A-shares are more volatile relative to their offshore peers because the onshore market is dominated by retail investors, who tend to be short-term-focused. More recently, volatility in China A-shares has been rising because of uncertainty regarding the regulation and impact of China's capital market liberalization on the local stock markets.
Chinese equities have a short history. The modern-day Shanghai and Shenzhen Stock Exchanges opened for trading in 1990, and the first Chinese company listed in Hong Kong soon after. In the early days, it was the larger, fiscally healthier and politically favoured companies that were allowed to list in Hong Kong or New York to draw upon a global investor base. This included companies such as 
China Mobile (CHL) and energy firm PetroChina (PTR). Shenzhen- and Shanghai-listed companies, on the other hand, tended to be smaller, less established names.
Starting in 2002, foreign institutional investors who wanted to purchase A-shares had to be granted a qualified foreign institutional investor (QFII) license. Currently, foreign ownership accounts for just 1% of the local Chinese market, but this is expected to rise as the Chinese government expands the program as part of its efforts to liberalize its capital markets and currency. In November 2014, the Chinese government introduced another access channel for foreign investors with its Shanghai-Hong Kong Stock Connect program. Under this program, investors in Hong Kong and mainland China can trade and settle shares listed on the other market via the exchange in their home market, subject to certain restrictions.
In the 12 months through June 2015, the MSCI China A Index returned 111.9%, whereas the MSCI China Index returned 24.6%. The drivers of performance in the onshore market included looser monetary policy in China and a strong pickup in domestic investor trading activity ahead of anticipated large foreign inflows from the new Stock Connect program with Hong Kong. But the main driver of performance was a surge in margin lending by local brokerages to domestic Chinese retail investors.
Prior to 2014, the MSCI China A Index had significantly underperformed the MSCI China Index for four consecutive years. Reasons for this underperformance include a slowing Chinese economy, falling earnings and local Chinese investors moving their money into higher-returning investment options such as real estate and wealth management products. In 2014, China reopened its IPO market after a 14-month hiatus. This halt was instituted as the government sought to improve oversight and strengthen regulations over the IPO market, which had been plagued by companies with weak financials. All of these issues highlight the many risks of investing in China stocks.
One of the commonly cited reasons for investing in China A-shares is for a more "complete" exposure to the Chinese investment universe. At this time, overseas China shares account for about 2.5% of a market-cap-weighted index of global equities. Adding A-shares exposure would result in a larger allocation in China, which may make sense given that China is the world's second-largest economy. Index provider MSCI is planning on adding China A-shares to its global equity indexes but is concerned about the access bottlenecks that exist for foreign investors.
