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Goldman Sachs Research With Chinese onshore and offshore equities rebounding13% and 15% from their respective September lows, and previously widespread domestic (China growth risk, FX uncertainty, policy efficacy) and external (Fed tightening, EM contagion) concerns moderating somewhat, investors are looking for visible catalysts to position in the market. The upcoming potential inclusion of China ADRs to the MSCI universe fits the bill, in our view, and has been one of the most topical issues in our recent conversations with investors. We summarize the FAQs we have received from investors and our responses below. To position for the ADR inclusion, we recommend China tech ADRs (part of our 4Q theme of "New China") and buying individual ADRs with strong fundamentals or call-spreads for limited downside risk. Q1: Is the inclusion ofChina ADRs to MSCI confirmed? A: The simple answer is YES, although it is still subject to final confirmation by MSCI. In January 2015, MSCI announced the enhancement of the coverage of their global investable market indexes by including foreign-listed companies to their respective country indexes. Besides China ADRs, foreign-listed stocks of 11 countries including Argentina, Israel and Hong Kong are also eligible for inclusion in the coming index reviews (page 164 in MSCI Global Investable Market Indexes Methodology). The eligibility is determined by two main considerations. First, the aggregate free-float adjusted market cap of all foreign listings to be included has to be at least 5% of the corresponding MSCI Country index and 0.05% of the MSCI All Country World Index. Second, at the single stock level, the potential inclusion candidate needs to satisfy the general requirements of MSCI index constituents including minimum size, liquidity and foreign access (pages 10-15 in MSCI Global Investable Market Indexes Methodology). In their semi-annual index review in May 2015, MSCI highlighted 14 China ADRs that are deemed eligible for inclusion based on the pricing and liquidity data as of April 20, 2015 (the MSCI official spreadsheet for impact simulation). Our calculation shows that the combined free-float adjusted market cap of these 14 names is 17%/0.5% of MSCI China/AC World index, essentially fulfilling (in fact exceeding) the abovementioned requirements. Q2: When will it happen and how long will the process take? A: The inclusion will beimplemented in two batches in the November 2015 and May 2016 Semi-annual index reviews. In particular, MSCI will add securities of all eligible foreign-listed companies at half of their free-float adjusted market cap weight in November 2015 and the remaining 50% in May 2016. For the November 2015 Semi-Annual Index Review, the announcement date will be on November 12 and the effective/implementation date will be on December 1. And for the May 2016 Semi-Annual Index Review, the announcement and effective date are May 12 and June 1, respectively. Q3: Whatstocks will be included? A: 14 China ADRs are eligible for inclusion as perMSCI's announcement in May. We think it is a sensible universe to begin with, but due to the recent price volatility and changes in liquidity profile as well as potential privatization deals which may take place/finalize before the inclusion date, stocks which will get the final nod could be different from these 14 names. However, we think the 3 largest constituents in terms of free-float market cap, which are BABA, BIDU, and JD, should make the list as they collectively represent 74% of the 14-name universe free-float cap (US$177bn) based on our estimate. Q4: What would bethe impact on China’s weight in EM, APJ, and AC World after the inclusion process? A: China’s weight in MSCI Emerging Market index (MXEF) and MSCI Asia-Pacific ex Japan (MXAPJ) couldrise approximately 4pp to 28% and 25% by May 2016, respectively, based on current prices. China is already the largest market in these two indexes at present but higher weights from China mean that key markets in EM (Korea, Taiwan) and APJ (Australia) could see disproportionately high reductions in benchmark weights. For MSCI AC World, China’s weight may potentially increase from 2.4% to 2.9% when the inclusion is completed based on our analysis (Exhibit 1). Exhibit 1: China's index weight in EM and APJ could go up by around 4pp post the inclusion, with Australia, Korea and Taiwan potentially seeing the biggest reduction in benchmark weights
Source: FactSet, MSCI, Goldman Sachs Global investment Research. Q5: What would be the impact on sector weighting within MSCI China after the inclusion process? A:More Tech and 'New China', less Banks and SOEs. Fast forwarding to May 2016, the weight of IT (GICS level 1) in MSCI China could increase to 26% from 14% now while Financials could see the largest drop, down 7pp to 34%, with banks taking most of the hit (from 22% to 19%). Currently, China ranks the 6th in terms of country sector weight for IT out of the 46 countries in the MSCI AC World universe, and China could rank 3rd (after Taiwan and Korea) if the 14 ADRs are included. As far as the Software sector is concerned (a GICS 2 Industry Group), China could rank the highest globally (24%) post the inclusion, leapfrogging India (21%) and the US (12%). We view this as a strong statement underpinning the idea that economic rebalancing is happening in China, and the equity benchmark is increasingly reflective of that macro shift. Exhibit 2: Tech and Consumer Discretionary could see the biggest increases in index weights after the inclusion, which may put China as the MSCI country with the highest sector weight from Software globally
Source: FactSet, MSCI, Goldman Sachs Global Investment Research. Q6: What is the key assumption in our index weightcalculations? A: The free-float factor for BABA. We assume a FIF (Foreign Inclusion Factor) of 45% for BABA, instead of the 25% as shown in the simulation spreadsheet by the MSCI when it was published this May. We made this adjustment to account for the effect of the 63% share lock-up expiration of BABA on September 19. At 25%, China's index weight increase would be 2.9pp and 2.7pp in MXEF and MXAPJ, and the aggregate net buying would be 19% smaller than what we currently forecast (also see Q7). For reference, the FIF for Tencent is currently at 55%, with holdings from key founding shareholders and top management deemed as free-floating shares. Q7: How muchbuying flows could this inclusion create? A:Our base case is US$78bn for the whole inclusion process. Admittedly, our (any) flow estimate is highly dependent on the size of money pool which is tracking the underlying indexes (MSCI China, EM, APJ, ASJ, BRICS, Global, etc.). Among these asset pools, EM is probably the largest and where we could get more reliable estimates in terms of asset sizes. MSCI estimated that around US$1.7tn of assets are benchmarking against the MSCI EM index as at June 2014. Using this as our central premise, we estimate the inclusion could usher in US$78bn of net buying for ADRs, averaging 22 days of ADVT. The potential full-period net buying is simply calculated as the amount of tracking assets multiplied by the pro-forma index weight of ADRs (4.7% of EM) by end May 2016. Some investors argue that the US$1.7tn assets tracking the MSCI EM looks high. As such, we provide a sensitivity table in Exhibit 3 which shows the resulting net buying under different assumed sizes of EM asset pool. In any case, we believe the potential over-estimation of flows could be partly offset/alleviated by the active and passive buying from other index-tracking pools as well as only modest overweight positions (and significant underweight on a pro-forma basis) by global EM funds on China Tech at the moment. Exhibit 3: Assuming US$1.7tn of assets are tracking MSCI EM index, we estimate that the inclusion could usher in close to US$80bn of net buying; EM active funds would be underweight the tech sector by 300 bps on a pro-forma basis after the inclusion
Source: FactSet, Lionshare, MSCI, Goldman Sachs Global Investment Research Q8: How much of the flows is active vs. passive? A: Per MSCI's estimate, around US$1.5tn (i.e. 87%) out of the total US$1.7tn assets tracking EM could be classified as active mandates. This ratio however seems high relative to our previous analysis, which suggests passive mandates (ETFs and index tracking funds) are gaining importance vs. active funds in the US as well as in Asia (Exhibit 4). Unlike active mandates which have the discretion to run high tracking errors or even invest 'off benchmark', passive monies have to allocate their portfolios according to benchmark weights. Exhibit 4: The importance of passive mandates has risen in the US as well as in Asia
Source: EPFR, ETF.com, Strategic Insight (Simfund), Goldman Sachs Global Investment Research. Q9: What are the ADR names which could see potential biggest flows relative to ADVT? A: Using the logic and assumptions highlighted above, we estimate that EDU, NTES and BABA could see the highest flow impact in terms of days of buying (relative to their 6M ADVT). In the same vein, New World China Land, COSCO Pacific, and Haitian may see the highest liquidity pressure among the existing MSCI China index constituents. Exhibit 5: Some potential beneficiaries and losers from an index-flow perspective assuming China ADRs are included in MSCI
Source: FactSet, I/B/E/S, MSCI, Goldman Sachs Global Investment Research. Q10: Is index inclusion a positive market event? A:Yes, empirically, but history may not be a good guide. Examining the aggregate market and newly-added constituents' performance during major index inclusion events in the past 15 years, we note that both the headline index and the new constituents tended to trade well around the event. On average, MSCI China and new constituents returned 4% and 3% one month after the inclusion, although the comparability of past episodes could be low as "fast tracking" (new listings were added to the benchmark right after their IPO) could distort the historical post-inclusion index and stock returns. Exhibit 6: Market and newly-added stocks tended to trade well around the previous inclusions
Source: FactSet, MSCI. Q11:How do you recommend to position for the upcoming ADR inclusion catalyst? A: We have been advocating the theme of "New China" vs. "Old China" as one of our preferred longer-term themes in the region (see 4Q tactical rebound, but 2016 strategic headwinds, Sep 30, 2015). Within the "New China" theme, we highlight US-listed China tech ADRs given factors including the upcoming MSCI inclusion catalyst and stronger earnings outlook within the Chinese listed universe. We prefer buying individual ADRs with strong fundamentals that are likely to see flow tailwinds in 4Q due to the MSCI inclusion (as shown in Exhibit 5). Buy-rated stocks include Alibaba, Baidu, VIPSHOP and Jumei. Investors looking to limit their downside risk can buy call-spreads on individual stocks or a basket of ADRs. As an example, a Dec 2015 (18th Dec) expiry 110/125% call-spread on BABA indicatively costs 2% with the overall structure providing a maximum payout of 7.5x at expiry. Similarly, an equal-weighted basket of 14 ADRs offers attractive risk-reward (75% 2016 EPS growth, 23x 2016 P/E) with a Dec 2015 expiry 110/125% call-spread indicatively costing an average 2.5% (6x maximum payout at expiry). Risks: Buyers of 110/125% call-spreads risk maximum loss of premium paid if underlier rallies less than 10% by expiry.
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