Is it time to separate out China from the rest of emerging markets?

China’s growing weight within emerging markets means that increasingly investors will want to look at separating the country out from the rest of emerging markets. That was the consensus of the asset managers FSA spoke with, some of whom have launched their own emerging markets ex-China strategies in recent years.

“If you went back to around the early 2000s, the index looked very different to what it looks like now. You had no dominant country in the index and you actually had a very large diversification of different countries,” said Navin Hingorani, portfolio manager at Eastspring Investments.

“But then you go through to around 2019 or 2020, China had reached 40% of the index and at that point it was almost the weight of the next two or three countries. It’s come down a little bit since then but even where China is today, it’s more than double the weight of the next largest country.

“Invariably, what we have seen happening is some of the other markets in EM have been crowded out by the increasing dominance of China in the index. You can look at foreign participation in a lot of other markets, it has come down significantly. So there is an opportunity here in an EM ex-China context to actually have a more meaningful allocation to some of these other countries.”

Funds on offer

The number of emerging markets ex-China funds that have been launched to date remain scanty. The Eastspring Investments – Global Emerging Markets ex-China Dynamic Fund was launched in May 2021 and has achieved a -5.7% return since its inception compared with a -8.9% return for the benchmark, according to its latest factsheet.

Its largest holdings include a smattering of semiconductor and hardware manufacturers such as Taiwan Semiconductor Manufacturing (9.1%) and Samsung Electronics (8.8%). Its largest markets are Korea (20%) and Taiwan (19.7%).

Another similar fund is the William Blair Emerging Markets ex-China Growth Portfolio Attributes Fund, which was launched in 2021 as a private fund vehicle with seed money and in July last year. The mutual fund was launched with an existing client in William Blair’s broad EM Growth strategy.

The fund has achieved a return of -17.8% since its inception compared with a return of -10.41% for the benchmark index. Its largest holdings are also Taiwan Semiconductor Manufacturing (11.8%) and Samsung Electronics (6.5%).

The reason for the limited number of emerging markets ex-China funds that have been launched is hard to decipher, although Romina Graiver, portfolio specialist at William Blair, reckons it is only a matter of time before we see more fund launches.

“I think it’s coming. I think we’ve been relatively early movers because we are really working with very sophisticated clients and forward-looking consultants,” she said. “A lot of managers who are creating these strategies now, they are looking at the large-cap space in particular.”

No time like the present

So why does it make sense to launch an emerging markets ex-China fund now? For one thing, China’s weighting in the MSCI emerging markets index has actually been falling in the last few years, not rising, which would seemingly undercut the argument that there is a risk that it overwhelms the index.

Although, the drop has not been significant. According to its most recent factsheet, China’s weighting in the MSCI emerging markets index stood at 38.5% having reached as high as 41% two years ago.

Eastspring’s Hingorani points out that this is likely to be an aberration, especially when China A-shares are currently only incorporated in the MSCI emerging markets index using a 20% inclusion factor so once this is increased, the weighting of China A-shares will increase significantly.

There are other more prosaic reasons for launching an emerging markets ex-China fund as well. For one thing, China has become increasingly desynchronised from other emerging markets since the Covid-19 pandemic hit and is now adopting a divergent monetary policy from most other countries.

Another factor is that global investors increasingly want to express a viewpoint specifically on China, whether positive or negative, as geopolitical tensions with the West have risen, the government has embarked upon its regulatory clampdown in the tech sector and equities have sold off in recent years.

“One of the observations that consultants and clients came to us with was that most investors have been consistently underweight China for a long time and some clients wanted to correct that,” said William Blair’s Graiver.

“But over time, we’ve also seen the other side of the equation so interest, especially from North American clients and to some extent interest from European clients, about the possibility of actually not having any exposure to China altogether.”

Chance to shine

So what impact does excluding China from emerging markets have on a portfolio? For one thing, it substantially increases the weighting of IT companies in the fund. China’s tech giants such as Alibaba, Meituan, JD.com and Tencent are instead accounted for in the consumer discretionary or communication services sectors.

Probably the biggest selling point is that it allows other countries the chance to shine. Korea and Taiwan notably become the largest markets in the fund, which is quite timely given the fact that there has been a huge rally in both their stock markets so far this year due to the outperformance of the semiconductor and hardware sectors.

India is also another market that typically sees its weighting increase substantially, although the view on whether that is a good thing is more controversial. On the one hand, India has favourable demographics, a rising middle-class, a stable political system and some of the most dynamic consumer tech names outside China.

On the other hand, valuations tend to be quite stretched. According to its most recent factsheet, the MSCI India price-to-forward earnings ratio stood at 19.80x compared with 11.78x for China. Although, William Blair’s Graiver noted that valuations have dropped off lately, providing attractive entry points.

“One of the reasons we are excited about this strategy is that India is a place that we are structurally overweight. We’re quality growth investors and from a quality growth perspective, the opportunities in India are very large. We like the structural story a lot and actually valuations have corrected quite meaningfully in the last quarter,” she said.

One of the broader concerns about an emerging markets ex-China fund is whether there are enough liquid stocks available, although Eastspring’s Hingorani reckons that is not a problem.

“If you actually just look at the broader universe within an EM ex-China universe, there are just over 1,000 stocks that have a market cap of more than $2bn. That is more than you have in Japan and more than you have in the EU ex-UK. Of those 1,000 stocks, more than 50% of them trade more than $10m a day and that’s very comparable to other indices,” he said.