A strategy of stripping China out of emerging-market portfolios is fast gaining traction as stock managers seek to reduce the risk of investing in a country that faces unique policy and geopolitical headwinds.
Nearly non-existent before 2015, such products sprang up last year as the investability of Chinese equities came into question, with 12 launches including from Goldman Sachs Asset Management. Another five came to the market in the first half of 2023, including BlackRock Inc.’s fund, according to data compiled by Bloomberg.
The budding trend underscores a growing belief that the country is too big and complicated to be lumped with others. Its stocks now account for nearly 30% of MSCI Inc.’s emerging market gauge. That’s particularly problematic as China’s equities are on track to underperform global stocks for a third straight year as tensions with the West, private-sector crackdowns, and a slowing economy hamper returns.
“One has to ask what are the potential consequences should China get involved in a conflict with other parts of the world — in that event, what would happen to your investments related to China?” said Victor Zhang, chief investment officer for American Century Investments based in Kansas City, Missouri. “That’s a legitimate question and supports a long, secular trend of thinking China as a segregated allocation.”
MSCI launched its emerging markets ex-China Index in 2017, but the strategy took off in recent years following China’s draconian Covid restrictions and an underwhelming post-reopening economic boom. Beijing’s reluctance to deploy big stimulus and structural headwinds including a shrinking population are giving investors more reasons to look elsewhere for returns.
READ: Global Money Is Chasing China Alternatives as Anxiety Grows
The MSCI China gauge has fallen 8% this year, on track for a third straight year of losses. Meanwhile, a developing-market index excluding Chinese firms has advanced 11% as the artificial intelligence boom lifted the tech-heavy markets in South Korea and Taiwan, and Indian shares rose to record highs.
“Geopolitical risks, regulatory risks and broad concerns regarding the investability of China have been bigger drivers of increased interest” in the products, said Romina Graiver, a portfolio specialist at William Blair International Ltd., one of the early entrants into emerging markets ex-China strategies.
Total assets held in the iShares MSCI Emerging Markets ex-China ETF have swelled to about $4.4 billion from a meager $165 million at the end of 2020, according to data compiled by Bloomberg. In comparison, the market value of the iShares MSCI China ETF has increased by just 19% to around $8 billion over the same period.
Money managers at Allianz Global Investors, AllianceBernstein LP and BNP Paribas Asset Management are among those who told Bloomberg that they see increased interest from clients.
That’s not to say investors are abandoning China exposure. As the world’s second-largest economy and home to tech behemoths including Tencent Holdings Ltd. and Alibaba Group Holding Ltd., the market is too big to ignore for some.
Money managers have likened the shift to what happened to the US and Japan decades ago, when their growing clout warranted a standalone allocation. With $10 trillion in stock market capitalization, China boasts a swathe of companies that remain untapped by overseas investors.
“Given its importance in the global economy, China deserves its own direct allocations,” said Christian Abuide, head of asset allocation at Lombard Odier. “Short-term macroeconomic considerations, geopolitics and sentiment should dictate much of the flows and performance picture, but longer term, China is here to stay.”
Some investors also say the slump in Chinese stocks has made valuations attractive. The Hang Seng Index, where a majority are mainland firms, is hovering near a bear market and is trading less than 10 times its forward earnings estimates, one of the cheapest among major markets in the world.
Carving out China will allow more focus on other emerging markets in Asia, where foreign fund flows have picked up to $25.4 billion this year, set for the biggest annual purchase since 2016, according to data compiled by Bloomberg.
“The impact of such a dominant country in a global index may crowd out opportunities in other emerging markets,” said Navin Hingorani, a portfolio manager for Eastspring Investments, which launched the Global Emerging Markets ex-China Dynamic Fund in 2021.
And while some dip-buying may emerge, an analysis by Morgan Stanley quants shows long-only active managers in the US and Europe have deepened their underweight position on China in June.
“We are now seeing clients actively asking for such mandates or putting in investment guidelines restricting exposure to Chinese assets,” said Paras Gupta, head of Asia portfolio management at Union Bancaire Privee UBP. “This underscores a clear trend that investors are seeking China-free investment options within the broader EM space.”
--With assistance from Irene Huang and Ishika Mookerjee.