Page 516 – Top1000funds.com

Distinct regulation of United States public pension funds that links the liability discount rate to expected return on assets, rather than to the riskiness of their promised benefits, sets them apart – in a bad way. US public funds have underperformed other pension fund cohorts because of higher allocations to risky assets. Arguably, regulation is at the core of that decision.

A new paper by Aleksandar Andonov and Rob Bauer from Maastricht University and Martijn Cremers of the University of Notre Dame shows that US public funds have an annual underperformance of more than 60 basis points from 1990 to 2010 compared to their peers.

The underperformance, the authors argue, seems to be driven by the conflict of interest between current and future stakeholders, and could result in significant costs to future workers and taxpayers.

Pension fund asset allocation and liability discount rates: camouflage and reckless risk taking by US public plans? compares the asset allocations, liability discount rates and performance across six groups: public and private pension funds in the US, Canada and Europe using the CEM database.

Distinct from any of the other five groups measured in the study, the US public fund regulation links the liability discount rate to the expected return on assets rather than to the riskiness of their promised pension benefits. This means they behave differently from all other pension funds.

Even within the US, regulation is very different: public funds are regulated by the Government Accounting Standard Board, while corporate funds are regulated under the Pension Act 2006.

Stacking up the stats

Significantly in the past 20 years, the group of US public pension funds measured have uniquely increased allocations to riskier investments to maintain high discount rates – and oddly this is especially the case as more members retired.

On average, the percentage of retired members among private plans increased from 31 per cent in 1993 to 52 per cent in 2010, and from 28 per cent in 1993 to 39 per cent in 2010 among public pension funds.

Economic theory suggests that asset allocation and liability discount-rate choices should be more conservative as the fund matures. But with US public funds, the proportion of retirees relative to non-retirees is positively related to the allocation to risky assets.

The study found that a 10-per-cent increase in the number of retired members of US public pension funds is associated with a 2.05-per-cent increase in the allocation to risky assets, while a 10-per-cent increase in the number of retired members is associated with a 1.16-per-cent lower allocation to risky assets among all other pension funds.

This results in the funds “camouflaging the degree of underfunding” the paper argues.

“If the liability discount rate equals the expected rate of return, it makes liabilities very hard to measure. It is subjective and hard to argue about,” one of the authors, Martijn Cremers says. “Liabilities shouldn’t be hard to define or be so subjective.”

Cremers, who is professor of finance at Notre Dame, says US pension funds need to be objective as possible about their liabilities, which would allow an equally objective assessment of the outcome and current promises.

It is then possible to do asset liability modelling and think about asset allocation with the right perspective.

Peer relative

According to the authors, US private pension funds, and both public and private Canadian and European pension funds are subject to significantly stricter regulatory guidelines. Their regulations generally require that liability discount rates be chosen as a function of current interest rates.

“We argue that the distinct regulatory framework for US public funds gives them strong incentives to shift a larger allocation to risky investments as this increases the assumed expected rate of return on their asset portfolio and thus (through their regulation) results in higher liability discount rates,” the paper outlines. “This in turn helps these pension funds camouflage their degree of underfunding and potentially delay making difficult decisions on contribution levels and pension benefits. Over the last two decades, increased allocations to assets with higher (assumed) expected returns have allowed US public pension funds to maintain high-liability discount rates, even as interest rates significantly declined.”

Cremers argues it is finance 101 to link the liability discount rate to investment grade yields.

Other academics have also argued this (for example, Robert Novy-Marx and Joshua Rauh of the National Bureau of Economic Research), but uniquely it is the regulation of US public pension funds that continues to ignore this finance missive.

Financial theory suggests that future streams of pension benefit payments should be discounted at a rate that reflects their inherent riskiness, particularly their covariance with priced risks.

Academics have been proposing the use of liability discount rates based on yields on government and municipal bonds and swap rates.

“In our empirical analysis, we find that pension funds generally lower liability discount rates as interest rates decline, which is consistent with both their regulations and economic theory.

However, US public pension funds are again different, as we find no association between liability discount rates and interest rates. This is consistent with their incentives and their distinct regulation that explicitly links liability discount rates to their expected rate of return on assets rather than to the level of interest rates. This result holds even while controlling for the proportion of assets invested in risky asset classes, which means that US public pension funds have made the economically surprising choice of not lowering their nominal expected return estimates on risky assets as interest rates decline.”

In the early 1990s yields were 7 to 8 per cent, so Cremers says it made sense for the return expectation to be 7 to 8 per cent. But as yields have declined, the return expectations have not declined.

A prudent assessment of reality

“The prudent thing is fairly unambiguous. With US public funds, regulation gives strong incentive to kick the can down the road,” Cremers says.

“US public funds are not making asset allocation on where opportunities are or true asset liability matching, but on camouflage, on short-term responses,” Cremers says.

Perhaps the most important aspect of the study, however, is the emphasis on the fact that US public pension funds are not being transparent about the true state of the underfunding position.

“Whatever the policy, it needs to be based on a prudent assessment of reality,” Cremers says. “The first step is to identify the current pension status, which is worse than people say. And regulation that gives incentive to public pension funds to invest in risky assets is imprudent.”

While funds admit that they are underfunded, academics and study by the Pew Report, show the situation is much worse than reported.

Cremers says the average funding level of US public pension funds is 80 per cent, but in reality it is much worse, with Pew estimating it is 57 per cent.

“If a more realistic liability discount rate is used, then it is a more dire picture of funding status. But then we can talk about how to respond, and at least there is a conversation about where we are,” Cremers says.

“As a financial economist, I can say that you make better decisions if you are realistic about where you are.”

As another fiscal year draws to a close Tim Walsh, director of the New Jersey Division of Investment, investment managers of the $75.64-billion New Jersey Pension Fund, reflects on another good year.

“It’s been a double-digit year with the best asset classes, plain vanilla US equities and structured credit,” he says speaking from the Division of Investment’s Trenton headquarters.

United States equities’ contribution to performance was enhanced last May when Walsh positioned the fund to benefit from the equity lift-off even more, upping its exposure by 4 per cent, creating an overweight position of 28 per cent of plan assets. It’s just the kind of agile strategy for which New Jersey is increasingly known.

The Division of Investment invests on behalf of the 769,000 members of New Jersey’s seven public pension funds.

The fund is divided into broad categories comprising a global growth fund (56.79 per cent) made up of US and non-US equity, emerging market equity, plus equity hedge funds and venture capital; income (23.63 per cent) comprising investment grade credit, high yield fixed income and debt-related private equity among others; a liquidity allocation (8.73 per cent) comprising treasury bonds and inflation-linked bonds; a real return bucket (7.65 per cent) including commodities and real estate; and risk mitigation (2.55 per cent).

Wary of the rosy equity view

Walsh has now grown circumspect of the rush into US equities – what he calls the rosy view of the US.

“There seems to be a broad consensus that US stocks are good and everything else is evil,” he says. “It concerns me because the consensus is usually wrong.” Now his eye is on what he calls beaten-down areas, such as high yield.

He believes technology and parts of the energy sector are cheap, but it is emerging markets, one of the worst performing assets of last year, where he sees most opportunity. The fund doesn’t pick individual stocks here but invests via exchange traded funds, currently allocating between 7 and 8 per cent of plan assets to emerging markets.

“We’ll add to this,” he says. “Emerging markets are the asset class to be in. If you could get the state-owned enterprises out of the benchmark, performance would be even better.” Despite the euro crisis, he has been encouraged by the fortunes of some European multinationals in Switzerland and the UK. He’s worried about rates rises “backing up” and predicts that although the markets for the most part are liquid, it will be harder to find opportunities going forward.

New Jersey, new hedge fund model

New Jersey Pension Fund’s May restructuring also pared the fund’s allocation to hedge funds, honing strategy to especially tap hedge funds in emerging debt and small global macro strategies that bring diversity to the portfolio. Allocations to hedge funds sit across the entire portfolio.

“We don’t have a broad bucket called hedge funds,” explains Walsh, adding that the fund favours customised relationships with its hedge fund managers, with tailored strategies and side-by-side investment.

“The 2/20, no preferred-returns model is dead. We haven’t put any money into a traditional hedge fund for over a year and we have actually withdrawn some,” he says in reference to the model whereby managers charge 2 per cent of the total value of the assets invested and 20 per cent of the returns.

Working alternatives hard

The alternatives portfolio, which “requires a lot of work,” is managed in house by New Jersey’s increasingly sophisticated team of 60, also now managing 90 per cent of the fund’s liquid assets.

It amounts to about 70 per cent of the total portfolio, more than any of other of the 11 biggest US schemes.

Inhouse management paid off particularly well last year with the fund’s active allocation to US equity.

“The active portion was our strong suit,” he says. For Walsh, who joined New Jersey in 2010 from Indiana State Teachers Retirement Fund where management was all external, developing New Jersey’s inhouse operations is one of the best parts of the job. “I do quite a lot of the rebalancing and the asset allocations – it really thrills me.”

New Jersey hasn’t increased its real estate allocation (4.89 per cent) but Walsh does see more opportunity in the asset class from now. It has just split its real estate portfolio into separate debt and equity allocations. Banks selling off their real estate portfolios is one seam.

He believes “industrial is pretty cheap” and also sees potential in hospitality. However, overvalued US markets in downtown Manhattan, Washington DC and Boston are prompting him to cast his eye on assets overseas. “There are better opportunities outside the US, going into China, India and South East Asia.”

New Jersey will get its final numbers on last year in the next couple of weeks. “We are a pension fund with long-term horizons, but we are nimble if we need to be,” says Walsh.

Affluent small European nations such as Denmark easily count among the world’s most outward-looking places, and DKK 95-billion ($16.4-billion) investor Unipension clearly casts its eyes far and wide from its headquarters in suburban Copenhagen.

While nearly all investors look for some exposure in the world’s key markets, Unipension has enhanced its international focus by actively eliminating home bias in spaces where others dare not. The investor – which controls three labour-related pension funds – recently decided to sell its entire Danish property holdings and invest the proceeds in international real estate funds.

A fully international approach is a bold move in an asset class that most investors are more comfortable in close to home. To Niels Erik Petersen, Unipension’s chief investment officer, it was a logical step for the investor.

“In all our investments we have a core-satellite international diversification strategy, but in real estate we only had Danish exposure so we wanted to diversify here as well,” Petersen says. The move, which will also see real estate allocations harmonised at 5 per cent across the three funds Unipension controls, will concentrate primarily on the United States and Western Europe.

Just 5 per cent of Unipension’s liquid portfolio (incorporating all assets excluding real estate) is invested in Danish equities, and Petersen says the fund has tried to avoid a home bias in this asset class as well.

“Denmark has a very small market, so there are a lot of opportunities outside of our region that help us balance the risk of our portfolio,” he explains. Petersen points out though that the international focus should not be interpreted as an abandonment of the investor’s homeland though, with the smooth functioning of Danish capital markets a key focus of Unipension’s active ownership strategy.

Careful global approach

“Diversification is important on our fixed income side, but what’s also important is that you get your money back,” says Petersen. Danish government bonds and high quality Danish mortgage bonds are therefore a significant part of the 39-per-cent gilt-edge-bond portfolio. Other “core” European government paper from the likes of Germany and Holland occupy the rest of that position.

Despite being an international fund, Unipension naturally has no desire to be impacted by regional pitfalls, and it therefore divested from southern European government bonds in 2009.

Petersen reveals that an unintentionally off-putting research trip led to Unipension moving away from the continent’s more indebted government bonds well before most other European investors followed. He was part of a group that met with a number of figures in Athens a few years ago with the firm intention to increase Unipension’s holding of Greek debt.

Discovering the true extent of the crisis conversely led Unipension to quickly drop its holdings in not only Greek but also Spanish, Italian and Portuguese government debt – a call that looks inspired in hindsight.

A dependence on external managers for Unipension’s vast emerging market portfolio (11 per cent of liquid assets are in emerging market debt and 29 per cent in overseas equities) means no such research is necessary in this space. The emerging market debt holdings have increased in recent years at the expense of gilt-edged bonds, with equity holdings also increasing gradually due to their strong performance.

A 12-per-cent allocation to high yield in the liquid portfolio “has been useful” says Petersen, who indicated Unipension had no doubts about the assets despite high yield investors suffering in this summer’s market turbulence.

Again Unipension appeared to have timed its tactical approach well with a move down from an overweight position on high yield being made in 2012. This was definitely “not a macro call”, Petersen points out though, as the fund simply saw better protection in loans.

Thin pickings lead to alternatives

Petersen explains that implementing a “duration overlay” had been a key strategic change in the recent past in an effort to extend the duration of assets to match liabilities, but this was reversed last year. “

Everything is pointing to a scenario of low returns in the coming years,” he says, betraying an outlook marked by pessimism. The investment head does not expect a “tremendous” performance in equities. Low interest rates also make the prospect poor for bonds in his view.

A natural consequence of that grim view would seemingly be for Unipension to diversify its asset base as much as it has its geographic spread. Petersen confirms this process is well under way with a private equity portfolio being launched in recent years and since increased to 4 per cent of liquid assets.

“We will increase our private equity holdings further, no doubt about it,” he says. The private equity bucket has a US-tilt, while Unipension has discovered a liking for secondary holdings.

The investor could well join other Danish pension funds in making major attempts to develop infrastructure investments, according to Peterson. Unipension’s limited and relatively short liabilities make this less of a pressing need, although it has already looked at various potential projects.

Strong returns in the last few years perhaps make it easier for Petersen to express his fears for the future. Unipension has gained accumulated returns of over 74 per cent since the start of 2009, which is some 14 per cent higher than its benchmark. In 2012 it booked an annual return of over 13 per cent but there has been a noticeable slowdown in 2013, with returns of just under 3 per cent for the first half of the year.

Free but prudent

The trio of funds under Unipension’s control run nearly identical asset strategies, Petersen says, with a system of modulised mutual funds ensuring assets are efficiently pooled. Slight liability differences and risk appetite variations at the three respective boards require some fine tuning though, he adds.

As liabilities are guaranteed on a contingent basis (Unipension promises to deliver at least 1 per cent per year but has a get-out clause if returns fall below that), Petersen says the investor “has a large degree of investment freedom and we can really go for long-term returns”. That allows Unipension a bigger risk budget than its Danish counterparts, although in true conservative Scandinavian tradition, Petersen says the fund has actually kept its risk “very low” under its international diversification drive.

The global outlook of Danes has created a problem for Unipension in that it has found itself under fire at home, along with other pension funds, for emerging market debt investments.

They have been criticised on the basis that the investments might support undesirable regimes. Petersen explains that Unipension carefully follows guidelines and is willing to avoid any investment it deems irresponsible.

“We are here to invest and not make foreign policy, but we do like to invest on an ethically sound basis”, says Petersen, who calls for international guidelines to be developed to make sustainable emerging market debt investments easier.

Unipension includes environmental, social and governance experts on its central investment decision-making organs, and Petersen himself is a respected figure of the sustainable investing scene as member of the United Nations-backed Principles for Responsible Investment Advisory Council. He is pleased to have a leading role in a movement that he deems is gaining increasing importance. “Responsible investing is perceived a lot differently than it was 10 years ago,” he points out.

A policy portfolio is a poor reflection of investor preferences, argued Peter Bernstein. This philosophical question has now been empirically tested by MIT’s Mark Kritzman, who shows the inter-temporal disparity of a policy portfolio’s risk profile. He suggests a simple framework for addressing this deficiency.

Kritzman encourages investors to replace rigid policy portfolios with flexible investment policies.

It’s not unlike a dynamic asset allocation idea, except he uses different information or signals as the conduit for any change.

Kritzman, who is a senior lecturer in finance at the MIT Sloan School of Management and the president and chief executive officer of Windham Capital Management, presents empirical evidence, and a potential framework, to the philosophical argument put forward by finance historian Peter Bernstein.

Bernstein argued that a policy portfolio is a poor reflection of an investor’s preferences; instead, it may simply be a benchmark for determining the success or failure of active management.

Selecting a portfolio of asset classes that best meets an investor’s objectives, given the outlook for expected returns, risk and correlations at a point in time, is not desirable because it changes over time.

“The return distribution implied by a particular portfolio at one point in time may be quite different at another point in time – and investors want the distribution, not the portfolio. The portfolio is simply a means to an end. The solution to the problem, therefore, is to revise the portfolio as needed to preserve the desired return distribution or at least to give the next best distribution,” Kritzman argues in his latest paper, Risk Disparity. “Or in other words, to replace a rigid policy portfolio with a flexible investment policy.”

Addressing conflict

He says that investors have two conflicting goals of growing their assets and limiting their exposures to significant drawdowns.

“The policy portfolio is supposed to be a way of balancing those. There is an implicit assumption that a policy portfolio will deliver consistent risk profile, but they are actually highly changeable,” he says, adding that the standard deviation of a broadly diversified portfolio can range from 3 to 25 per cent.

“It is not a valid argument that a reference portfolio is giving you stability,” he says. “I argue that you should replace a rigid portfolio with fluid allocation to get stability.”

Kritzman says that investment strategy defined as a set of fixed weights doesn’t do a good job at all of seeing an investor’s risk preference.

“Fixed asset weights don’t do the job they’re supposed to,” he says. “Further, our two measures of risk, beyond standard deviation and correlation, give a more reliable measure of when markets are dangerous and a portfolio is susceptible to that.”

“Investors can get a more stable risk profile by opportunistically changing their exposure to risky assets,” he says.

While typically dynamic asset allocation is driven by metrics of valuation such as stocks versus bonds, Kritzman suggests a change in allocations by drivers of risk, and he looks in particular at two different types of risk.

Predicting volatility

Predicting portfolio volatility is a tricky science.

Implied volatility and historical volatility are both of limited value according to Kritzman, who instead argues investors use the absorption ratio to anticipate shifts in portfolio volatility.

He says this measure captures the extent to which a set of assets is unified or tightly coupled, which means they will exhibit a unified response to bad news.

Over the years Kritzman and various co-authors have used this measure to predict broad market fragility and among other uses the US Treasury Department’s Office of Financial Research used it in the analysis of early warning signals of financial crises.

Kritzman says it can be applied to measuring the fragility of any set of assets, including the components of an individual portfolio.

“It’s a measure of the fragility in external markets. For example, if US stock markets are tightly coupled then they are more susceptible to shocks. We have taken the same methodology and applied it to a portfolio. We end up having a measure of risk that gives external danger measures.”

He also looks at the intrinsic fragility of a portfolio, which is dependent on the assets in that particular portfolio.

What this means in practical sense, he says, is investors can start with a policy portfolio and if there is no external or intrinsic fragility, then stay with the status quo.

“In the paper I show that if there is a measure of one of these, then there is heightened fragility and the equities portfolio should be cut in half. If both show fragility, then cut back virtually all equities. This is a pretty extreme move and in reality it would probably mean cutting equities by 25 to 50 per cent,” he says.

Such a dynamic approach is possible because of the use of exchange traded funds or futures exposures and, as such, avoiding implementation costs.

From a strategic asset allocation point of view, AustralianSuper is one of the most aggressive investors in emerging markets, particularly Asia.

About a quarter of the $43-billion fund is in international equities, and nearly half of that is in emerging markets.

Equities is the vehicle for AustralianSuper’s emerging market exposure because growth remains the reason for its allocation.

“And equities are the main beneficiaries of growth,” says chief investment officer, Mark Delaney (pictured right).

Specifically the fund wants direct consumer exposure in Asia, and to do this has looked beyond a passive approach with major indexes – such as the MSCI All Country World Index – that have greater exposure to the financial and energy sectors in emerging markets.

It’s a valid strategy to look beyond passive investing in emerging markets, particularly given the mixed performance of equity markets that make up the index, and also the dominance of state-owned enterprises.

Conrad Saldanha, managing director and portfolio manager of emerging market equity at Neuberger Berman, says benchmarks are not reflective of the underlying economy – and that is true for both developed and emerging markets. But emerging markets have a number of unique characteristics which means active management is even more of an obvious choice.

Benchmarks in emerging markets capture the dominant drivers – commodities, financials and state ownership – which in some countries such as China are 90 per cent of the benchmark.

“You get the biggest capitalisation companies but it is not necessarily representative,” he says.

Where active management rules

Managing director and head of investment strategy and risk at Neuberger Berman, Alan Dorsey, agrees the beta story is not working well in emerging markets.

“It is a particularly good environment for active management. When the tide is going up and all the ships are going up, or the tide is going down and all the ships are going down, then the beta story is better. But there is mixed performance of emerging markets equities. Security selection is paramount,” he says

Phil Edwards, principal at Mercer in London, agrees there are a lot of opportunities for skilled active managers in emerging markets.

“Active managers make sense because of the risk management perspective as well, so using active managers is useful for that.”

Saldanha, pictured right, says his stock picking involves looking for quality businesses with secular growth opportunities, higher returns, lower debt with strong cash flows.

“We want to identify, evaluate and predict cash flow for those companies with a domestic focus,” he says.

He says there are good bottom-up opportunities in emerging markets, including in mid-cap companies and frontier markets.

According to Dorsey investors should consider the MSCI ACWI index as the starting point of their overall equities asset allocation, and then have manager tilts into various countries, some of which are emerging.

But he believes the tilts should be done on a security-selection basis – not on a country basis, which requires corporate and also global analysis.

“Asset allocation generally depends on the client’s objectives and their guidelines on absolute returns and relative returns. Many investors think of the question of whether to include emerging markets in a wider international equities exposure in terms of the index,” he says. “The weighting of the allocation to emerging markets is clearly centre stage. While not all emerging markets companies are stellar, neither are all developed market companies less attractive. You need to look at company selection globally.”

Finding your ideal weight

In Europe the reduction in allocations to domestic equities has seen a subsequent uptake in international allocations, including emerging markets.

Mercer’s Edwards says there has been a more global approach and funds are awarding global active equities strategies and, as part of that, emerging markets.

Among European asset owners, Mercer’s asset allocation survey shows the average allocation to emerging markets in 2013 is 5 per cent of total assets or about 10 per cent of equities, which is underweight compared to the proportion of emerging markets within the global equities universe.

The Finnish State Pension Fund, the €15.8-billion ($20.8-billion), VER is one European fund that has been quite aggressive in its emerging market allocations, and is currently overweight its strategic benchmark.

Timo Löyttyniemi, (pictured right) chief executive of VER, says the fund was a net buyer of emerging market equities during the crisis.

“We have had a benchmark structure for a few years where half of emerging market equity exposure is in a diversified emerging market portion and the other half is in an Asian emerging market portion. We tend to have an Asian tilt as a result of that. From time to time Russia has been a key performer for us, but performance has not been that good in the last two-to-three years so it has no special prominence in our strategy at the moment. Russia used to give us a major performance bonus but other than that there are no major country picks, but more of an Asian bias in a diversified strategy.”

Edwards is advising that funds look at increasing their allocations to emerging markets to be in line with the benchmark weight. The MSCI ACWI includes 24 developed markets and 21 emerging markets.

“Increasing to the benchmark weight seems sensible, and we suggest considering allocating above the market-cap weight,” Edwards says, advocating about 20 per cent to emerging markets.

In addition, he says there is an expanding opportunity set in frontier markets.

They have the characteristics that today’s emerging markets had in the 1980s, but there are limited capacity, risks and liquidity issues.”

Opening the world’s second largest economy

The changing nature and openness of emerging market financial systems mean that constant assessment of the environment is necessary.

MSCI is currently considering whether to increase the allocation of China’s weight in the emerging market index to include the nation’s A shares.

(Concurrently MSCI Korea and MSCI Taiwan Indices remain under review for a potential reclassification to developed markets).

The MSCI emerging market index currently only includes Hong Kong-listed H shares, and some China B shares.

Including the A shares in the index would dramatically change the nature of the benchmark, potentially increasing China’s allocation from around 18 per cent to 30 per cent.

China is already the largest single country weight in the index and this potential change would give it more impact. This obviously has implications for investors.

The Shanghai and Shenzhen stock exchanges have more than 2400 stocks, with a total market capitalisation of about $3.5 trillion.

Foreign ownership is only about 1 per cent of that, due for the most part to the stringent requirements of the Qualified Foreign Institutional Investor system and the slow deployment of its quota.

However MSCI is seeing enough change to conduct consultation on the country’s allocation.

Chin Ping Chia, managing director of MSCI (pictured right), says a series of developments have caused the review, including an increase in the quote of A shares available to foreigners from $30 billion to $80 billion.

“We see this as a signal to expand the system and allow more investors to participate.”

In addition the high qualification criteria has been amended.

It used to be that to get a licence you needed $5 billion in assets and a five-year track record. That was lowered in July last year to $500 million in assets and a two-year track record.

“This is a significant change and broadens the set of investors, which is a positive thing.”

China’s Renminbi Qualified Foreign Institutional Investor system has also been expanded from RMB70 billion to RMB270 billion.

“This is a positive message saying there is regulatory momentum to open the markets.”

However MSCI identifies a number of key obstacles that need to be overcome, including capital mobility restrictions, the small allocation associated with licences and the imposition of capital gains tax.

“China is the second largest economy in the world. It is very close to opening to international investment and we think this is the right time to be starting this conversation. But it depends entirely on the progress of the regulatory system. MSCI does not have a time frame, but we are engaging with the regulators so they consider the investment processes and needs of investors,” he says.

“It is also for investors to digest and think about the consequences. Only a small handful of investors – 200 – have QFIIs. A large number of investors haven’t taken action, so what does it mean to take action?

“In the context of every market, when they open and increase foreign institution participation it is a good thing. It mainstreams investment ideas and the market gets more efficient.”

Frank Yao, managing director of Neuberger Berman Asia, says it is a huge positive to include the A shares in the index.

“It is positive for international investors to access China. It is the second largest economy in the world, but international investors have no direct way to access it. It is also positive for domestic investors: if foreign investors come, the market becomes more institutionalised.”

In particular, he says, that would mean improvements in technology, corporate governance and transparency.

Yao says the government influence and management of the corporate sector has diminished over the years.

“There is new leadership, economic reforms and now China is being opened to the rest of the world. China will become more market driven. In many areas, like the housing and auto sectors, China is more capitalist than the US,” he says. “Last week the government announced it would open the banking sector. Five or even three years ago you couldn’t even imagine this would happen.”

While China will continue to grow, Yao says it is still an emerging market and is very inefficient.

“Investors need to have a long-term investment horizon and emerging markets are volatile. There are still significant alpha opportunities.”