China: Investing in the Middle Kingdom (Part 2)
With the Chinese equity market recently becoming a larger proportion of the MSCI Emerging Markets Index, and on a path to potentially being over 40% of that Index as A shares are fully included, investors should be assessing their approach to investing in this growing but complex economy.
Having explored some of the issues and opportunities in Part 1 of this series, we will now outline the primary options available for investors to manage their allocation to Chinese stocks, as well as the advantages and disadvantages of each.
Defining the nature of the problem
Currently, China represents about 32% of the MSCI Emerging Markets Index. If your EM equity allocation is benchmarked to that index, as most U.S. programs are, your baseline exposure to China would be somewhere around that level with the expectation that this will gradually increase to a currently estimated 41%.
Importantly, this only exacerbates an already concentrated index where today fully 73% of that index is in five countries (China, South Korea, Taiwan, India, and Brazil). So, within that index: 21 countries make up 27%, while 5 countries comprise the other 73%. If we take Brazil out of that mix, 69% of the MSCI EM Index is in Asia, much of which is also linked to the rise and fall of the Chinese economy.
Looking at individual stocks, this is confirmed in the index’s ten largest holdings, of which over 50% in cap weighting are in Chinese shares and 95% of that weight is in Asian markets. It is likely that as A shares are added to the index there will be even greater concentration.
Concentration with a rationale?
Yet if an investor wishes to focus on future opportunity, Asia may be the location of choice. In 2019 the IMF estimates real GDP growth in the region to be just under 5%, projecting somewhat above that level by 2024. Contrast that with other parts of the Emerging World (see table) and it is reasonable to conclude that investing in Asia is simply the path to the best growth opportunity.
|IMF Real GDP Growth|
Again for contrast note that expectations for the U.S. and Europe in 2024 are equal at 1.6%.
What are the options for investors?
The most straightforward option is to simply allow the benchmark, and changes thereto, to drive your allocation. As the MSCI or other benchmark providers increase the allocation to A shares, they would likewise increase for your portfolio, absent a strong active position contrary to that baseline.
The advantages here are that no concrete action is required and any mismatch to the underlying benchmark would be 100% determined by active decision making. The issues with this approach are several: first, this means that the primary determinant of your China allocation rests upon the whims (perhaps well thought out) of an index provider. Second, this means that it is likely that a dramatic proportion of your emerging markets exposure will be driven by a single region that is dominated by a single economy’s prospects. Finally, sector weights will be at least partially the result of the Chinese government’s continued support of State Owned Enterprises (SOEs), which are currently concentrated in financials and industrials.
A second option is to begin working toward a higher weight to Chinese equity now – acting in advance of what seems an inevitable rise towards 40+%. There are several reasons to support such a decision. It takes advantage of future increases in the allocations of many investors – buying before others act; it puts investors in the path of future Chinese growth; and finally, it is more aligned with China’s current global contribution to growth – even at 40% in the index that is still punching far below its economic weight in the world economy.
There are other effects, however, that might give investors pause, including increasing the benchmark mismatch and taking an active allocation position that is generally reserved for active managers. It also may create some management issues as the typical active manager may have to step outside their comfort zone if an investor seeks to modify their standard allocation position to support a current overweight.
In addition, if the mechanism to implement the overweight is to carve out China as a standalone, there are questions of manager availability, adequate due diligence, and the length of relevant track record.
Finally, an investor could conclude that putting 40% of their eggs into a single Emerging Markets basket would create less diversification than appropriate given the objective of such an allocation and therefore work to a lower-than-index weight and retain that weighting as A shares are included in the index.
This would result in a more diversified exposure to EM; protect the investor in the event that the China phenomenon somehow fizzles; and modify the sector weightings to avoid concentration in financials and industrials. Such an approach would, however, also usurp the active role of the typical asset manager in EM and may also create a need to somehow operationally carve out the resulting smaller China exposure with the attendant problems. Of course, just as with option two this also increases benchmark mismatch in a strategic rather than tactical way.
Some other factors to be considered
An actively managed China-only mandate seems to make strong intuitive sense as this largely retail driven market is generally viewed as highly inefficient and local experts would appear to have a strong advantage over foreign asset managers. Yet the data is inconclusive and spotty on that front.
Plus, a China-only carve out, as noted above, creates operational issues as your other EM manager(s) may have to turn to an EM ex China approach – outside their comfort zones or historical records. What if India and other Asia region countries, which have been more closed to foreign equity ownership, change those policies and become, a la China, more open to foreign shareholders? This could cause a whiplash by suddenly bringing down China’s relative importance in the index.
If China is to be carved out in some way, does that mean that Capital Market Assumptions will need to be developed for Mean Variance Optimizations in asset allocation studies? Is there sufficient data for that? Finally, are there considerations of style, capitalization, and factors that would impact how a China mandate should be managed?
Interesting perhaps, but how consequential today?
China is a big deal: in macroeconomics, and geopolitics. In the capital markets, still not so much. In fact from the level of A share inclusion as of 7/31/19 to a full inclusion sometime in the future, the China allocation moves from 3.7% of the MSCI ACWI (all country world) to about 5.7% - only a 2% increase to a globally weighted portfolio. Compare that to the impact of Microsoft, Apple, and Amazon within the S&P 500 in just the last five years where their total weight in that index went from 6.4% in 2014 to nearly 12% today.
Notwithstanding, if the emerging world, especially China, moves its equity weightings towards their respective shares of the global economy even with zero relative growth, they would head towards a global equity weight of 39% (16% in China) - that would be something, indeed.
China was once one of the most advanced countries on Earth and, via a host of wars and rebellions, became one of the least developed. In a little more than fifty years this has been reversed and China is, at least, in the middle of the global pack in a large number of ways.
Importantly, China’s goal isn’t to be in the middle, but rather to be in the lead. As Premier Xi said at a recent party congress, China intends to “be a fully developed nation by 2049 and a global power with a first-class military by 2050.” Yes, investors have some time to figure out the role of China in their investment portfolio, but take it from someone now in the business for over 40 years – it will fly by.
Segal Marco Advisors provides consulting advice on asset allocation, investment strategy, manager searches, performance measurement and related issues. The information and opinions herein provided by third parties have been obtained from sources believed to be reliable, but accuracy and completeness cannot be guaranteed. Segal Marco Advisors’ R2 Blog and the data and analysis herein is intended for general education only and not as investment advice. It is not intended for use as a basis for investment decisions, nor should it be construed as advice designed to meet the needs of any particular investor. Please contact Segal Marco Advisors or another qualified investment professional for advice regarding the evaluation of any specific information, opinion, advice, or other content. Of course, on all matters involving legal interpretations and regulatory issues, investors should consult legal counsel.