Quick – name the country with the second largest stock market in the world!

Obviously, we know that the US has the largest stock market in the world.  But did you guess Japan, Great Britain or France?  Those are good guesses since they are the three largest developed markets in the world.

Maybe you guess China, which is the fourth largest market in the world as measured by the weight of Chinese stocks in the MSCI All Country World Index (ACWI).

As of Friday. Chinese stocks represented 3.9 percent of the index compared to 51.9 percent for the US, 7.1 percent for Japan and 3.4 percent for France (I was surprised that Germany fell behind France at 3.4 percent).

It turns out that determining the world’s second largest stock market is a little more difficult than you might think.  If you don’t place any restrictions on your estimate, then China is handily the second largest market.

However, as you might expect from a centrally controlled Communist country, there are plenty of restrictions on Chinese stocks – so much so, that only two percent of Chinese stocks are held by non-Chinese investors.

There’s been a lot of trepidation by investors outside of China to invest, mostly because they (we) have been worried about issues like corporate government, liquidity and all kinds of things that we take for granted in the US.

But the situation is changing.  Two years ago, the index provider FTSE started to include Chinese stocks in their emerging markets indexes and last week MSCI, another top index provider decided to do the same thing.

The inclusion of Chinese stocks into the commercial indexes is not simple, partly because foreign investors like us (well, like Vanguard, iShares, etc.) have to get approval from the Chinese government to own the stock.

Secondly, the phrase ‘Chinese stocks’ is a bit of a misnomer because there are all kinds of Chinese stocks: A-shares, B-shares, H-shares, Red chips and P-chips, more specifically.

For these reasons, the liberalization process will take years.  When South Korea and Taiwan were included in 1992 and 1998 respectively, the process took five to six years.

Personally, I think that the gradual inclusion of Chinese stocks into our portfolios is a good thing.  First, I like the additional diversification that these stocks deliver.  I also like the increased exposure to the world’s second largest economy.

Finally, I am philosophically pleased that China is adopting capitalism, even if it is a small and imperfect step at this point.  It’s just good to be on the right track.