The Case for Investing in Emerging Markets Beyond China

The article below is from our BRIEFINGS newsletter of 11 November 2021

Is there a case for dropping China from emerging market (EM) indices? We sat down with Goldman Sachs Research’s Timothy Moe and Sunil Koul to discuss the drivers behind the growing debate to invest in EMs, without China.

What’s driving the discussions among investors to separate China from the rest of their emerging market equity allocations?

Timothy Moe: First of all, a key factor is China’s significant market size and its rising dominance in the EM benchmarks. China’s weight in the MSCI EM index has roughly doubled over the past five years, from about 20% in 2015 to a peak of 43% in Q4 2020. And we expect China’s weight in global and EM benchmarks to increase in the coming years, especially as index providers begin raising the weight of mainland China stocks, known as “A shares.” With the rising dominance of China in EM benchmarks, EM investors inherently have to take a large exposure in China. Secondly, idiosyncratic factors, including geopolitical concerns such as U.S.-China tensions and China’s recent regulatory crackdowns, have driven sharp underperformance of Chinese equities versus other EMs. This has fueled the need for investors to better manage China risk and highlighted the merits of separating China from the rest of the emerging markets.

Just how large is EM ex-China as a separate market or index?

Sunil Koul: EM ex-China as a separate market or index is quite large in terms of its capitalization and offers significant depth and liquidity. Within the MSCI EM index, EM ex-China currently includes about half of the 1,400 stocks and two-thirds of the index capitalization. And within a universe of larger-cap listed stocks globally (measured as having at least $2 billion of market capitalization), the U.S. market, not surprisingly, has the highest number of larger cap stocks while the EM ex-China region has the third highest number, with about 1,200 larger-caps stocks. In terms of liquidity, more than half of these larger-cap stocks in EM ex-China trade at least $10 million a day.

Why would investors opt to invest in EM ex-China?   

Sunil Koul: While an EM ex-China index is less levered to China’s growth, it offers different market, sector and macro exposures to investors. EM ex-China, for example, has greater exposures to the tech and semiconductor sectors than China. It’s also more sensitive to U.S. tightening and commodities than Chinese equities. The benefits of portfolio diversification can have a significant impact on returns as shown by the wide disparity in performance of China and the rest of EM this year.

So how would a separate asset class for EM ex-China equities impact investors and their allocations?

Timothy Moe: With a separate asset class for EM ex-China equities, asset managers could control their China risk better, as historically they would have to take a large exposure in China given its index dominance. Against the current backdrop of geopolitical concerns and domestic regulatory risks in China, having a separate asset class will also allow global equity managers to create more efficient portfolios. In fact, our own analysis finds that the optimal portfolios—based on the efficient frontier created by separating China from the EM benchmark and having separate allocations to China and EM ex-China—would have offered higher returns or a reduction in risk compared with ones created by using EM as a single asset class. More broadly, we could also see greater allocation of resources towards EM ex-China markets, more EM ex-China financial products and greater investment flows, which bodes well for the asset management industry.

The last time a dominant country was separated from an equity index in the region was in January 2001 when the MSCI launched its Asia ex-Japan index. Are there any lessons learned?

Timothy Moe: Japan serves as a useful case study for how the investment terrain could change if investors separate China from the rest of the emerging market index. Both Japan and the region (ex-China) continued to receive cumulative net inflows and at a fairly consistent, roughly 60%/40% proportion. Based on the experience of how indices evolved and portfolio flows progressed following separation of the rest of Asian equity markets from Japan, it appears likely that both China and EM ex-China can be viable indices and attract investment flows with no cannibalization effect.