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China’s Growing Clout in Emerging Markets:
Causes, Investor Implications and Future Outlook
By: Eric Ramos, CFA, Consultant
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As of April 30, China represents 40 percent of the MSCI Emerging Markets Index. The 40 percent allocation is higher than the next four largest countries (Taiwan, South Korea, India and Brazil) combined. Two years ago the Index Provider, MSCI, began partially including China A-Shares within the MSCI EM Index. China A-Shares are companies listed in Shanghai and Shenzhen (mainland China) and are quoted in Chinese renminbi or yuan.
Historically, the MSCI China allocation was composed solely of Chinese domiciled companies that traded on the Hong Kong Stock Exchange and denominated in Hong Kong dollars. Although the initial inclusion of A-Shares was negligible, China has grown from 30 percent of the Index to 40 percent of the Index in two short years. Despite working through an ongoing trade war with the United States and being the origination country of the first COVID-19 outbreak, China has somehow managed to attain - and maintain - such rapid market growth.
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This growth in China’s market was not entirely unexpected; in fact, many signs indicated that such a leap was probable. With that in mind, investment managers need to be aware of China’s expanding role in the global markets and how it will affect future investments concerning China.
Two Primary Reasons for China’s Growth in Emerging Markets
While there are many contributing factors that led to China’s growth in the Emerging Markets Index, two reasons in particular are most evident:
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1. MSCI inclusion and eventual expansion of China A-Shares in Emerging Markets Index — Beginning in May 2018, MSCI began partially including China A-Shares within the Emerging Markets Index. The initial inclusion was quite modest, with MSCI implementing a five percent Index inclusion factor for Chinese A-Shares. The five percent inclusion factor was insignificant from an allocation perspective, adding less than one percent to the Index overall. However, more importantly, it was a sign of things to come.
For instance, in 2019, MSCI increased the inclusion factor from 5 percent to 20 percent in three separate stages. Additionally, as of November 2019, MSCI began including mid-cap A-Shares in the Index. With these changes, Chinese A-Shares now represent 4.7 percent of the Emerging Markets Index.
2. China’s equity markets outperforming the Emerging Markets Index — The addition of A-Shares in this Index is not the only reason China’s weight within it has increased. Since the beginning of 2019, Chinese equity markets have outperformed the Emerging Markets Index. Maybe most surprising was China’s outperformance in the first quarter of 2020 given the COVID-19 pandemic. Similar to the U.S. and the “FAANG” stocks, China has benefited from the performance of large companies focused on the digital economy and new and growing methods of communication.
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Guidance for Investment Managers with Regards to China
Investment managers have been forced to adapt and change their approach to investing in China. Managers may have been underweight in order to be more broadly diversified and to limit absolute risk, or they may have had concerns over the Chinese Government and state-owned enterprises. Although these risks certainly remain, managers also need to weigh the risk of tracking error and underperformance relative to the benchmark.
For instance, a manager may have added value through stock selection within the first quarter, but if they had a 30 percent allocation to China (instead of the benchmark weight of 40 percent), they may have underperformed for the quarter. MSCI has demonstrated their confidence in the Chinese stock market by its initial inclusion in 2018 and subsequent increases in 2019. Managers can either follow suit by increasing their allocation to China in order to align with the benchmark or have their relative performance be dictated by how Chinese stocks perform.
In Summary: China Truly Emerges, Investors Must Adapt
China could comprise nearly 50 percent of the Index in the next few years. MSCI could continue to increase the inclusion factor for the A-Shares. Additionally, we may see MSCI transition the second and third largest countries in the Index, South Korea and Taiwan, to developed markets. The Index provider FTSE Russell has classified South Korea as a developed country for more than 10 years. Market movements aside, it is very conceivable that investors will see China constitute more than half of the Index in the near future.
How does China’s growth in the Index change an investor’s approach to emerging markets and the broader asset allocation of portfolios? Could it mean allocating to a dedicated China strategy and complementing it with an MSCI Emerging Market ex-China strategy? If that were to happen, from an asset allocation standpoint, would that require separate modeling?
While answers to these questions are not readily apparent, the questions themselves are critical to future investment decisions and must be considered carefully.
For more information, please contact any of the professionals at DiMeo Schneider & Associates, L.L.C.
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This report is intended for the exclusive use of clients or prospective clients of DiMeo Schneider & Associates, L.L.C. Content is privileged and confidential. Any dissemination or distribution is strictly prohibited. Information has been obtained from a variety of sources which are believed though not guaranteed to be accurate. Information has been obtained from a variety of sources believed to be reliable though not independently verified. Past performance does not indicate future performance. This paper does not represent a specific investment recommendation. Please consult with your advisor, attorney and accountant, as appropriate, regarding specific advice.
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