Kirsty McLaren, Investment Director, Emerging Market Equities at Schroders
The debate around how investors should allocate to China has grown in recent years. Should they continue to include it as part of a global emerging market (EM) equity allocation, or carve the country out from EM and allocate on a standalone basis?
There are pros and cons to both approaches, each of which may carry greater weight depending on an investor’s objectives and constraints. As such, both have validity, but what’s crucial is that the decision on which path to take is made following an informed assessment.
What is driving the debate around how to allocate to China?
China is by far the largest component of EM benchmark indices. As of the end of March 2024, it accounted for about 25% of the MSCI Emerging Markets Index; the next biggest markets being India at 18%, Taiwan, 18%, and South Korea, 13%.
Standalone China funds have become more popular with investors, particularly in the last few years since the domestic market became more easily accessible to foreigners. Today, standard practice is to include China within a global EM allocation. However, more recently, many EM ex China strategies have launched. There are two key drivers behind this:
- China’s size has prompted a desire from some investors to allocate to a specialist manager, while allowing a broad EM manager to focus on delivering ex China returns.
- Asset owners’ desire to take control of their China allocation and therefore China risk themselves.
China approaches compared
There are benefits to both approaches
The fundamental question is whether the investor wants to retain direct control of their China allocation. Do they have a strong investment view on China? Do other factors drive a need for greater control? A single allocation to EM including China minimises the costs to the investor in terms of search, monitoring and fees compared to an EM ex China plus standalone China approach. It also unifies risk management across EM equities.
However, for a large, sophisticated investor with extensive resources, whether EM ex China plus standalone China is a more expensive approach than a standard EM including China net of fees hinges on two key factors: 1) Whether a specialist China manager outperforms a broad EM manager within China over the investment horizon, and 2) Whether the investor’s decision making in under/overweighting China is superior to that of the broad EM manager.
There is also a third option available to investors with a segregated mandate who are concerned about the dominance of China within EM. They can customise their benchmark and cap the allocation to China.
Key characteristics of China’s stock market
Since the gradual opening of China’s domestic stock market in 2014 to foreigners, the Chinese stock market has become one of the biggest in the world and offers a large and liquid opportunity set. Measured by market capitalisation in US dollar terms, Shanghai is the fifth largest exchange in the world, behind the NYSE, NASDAQ, Euronext and Japan, and Shenzhen is in seventh place. Both the Shanghai and Shenzhen Stock Exchanges host more than 2,000 listed companies.
China’s stock markets are dominated by domestic investors, with foreigners holding around 10% of the listed equities on each exchange. As the figure below shows, there are a wide selection of stocks available across the market cap spectrum.
Number of mainland China listed equities
High retail investor participation an opportunity
Owing to capital restrictions, China has a large pool of trapped domestic capital. Individuals in China typically have three investment choices – they can put their money into banks, real estate, or the stock market. This, along with a nascent institutional asset management industry, means that retail trading activity proliferates in China. At times it has accounted for up to 80% of the total domestic market volume. As retail investors often have shorter time horizons than other investor groups and may overreact to news flow, this can result in stocks being significantly over or undervalued for periods of time.
The high participation rate of retail investors reduces the overall efficiency of the market and provides opportunities for more sophisticated investors with rigorous investment processes and longer investment horizons to generate alpha.
Despite some recent challenges, China’s domestic equity market has historically been a fertile ground for institutional investors to generate alpha.
State-owned enterprises impact market efficiency
As the figure below shows, the share of SOEs in China is much higher than in the rest of Asia and the controlling shareholder may have priorities other than maximising shareholder returns. An active manager may be able to anticipate when the state’s interests will be aligned with minorities and when they will diverge.
Weight of SOEs in emerging markets
Rising regulatory activity
The last few years has seen a flurry of regulatory activity in China. Several factors have been behind this including a desire to ease rising inequality, to bring legislation in line with the pace of innovation (primarily in tech and e-commerce) as well as a need to move towards technology self-sufficiency off the back of geopolitical issues. Broadly speaking, the main thrust of regulatory activity has been on antitrust, issues of inequality, gig economy labour practices etc. This has wide ranging impacts for sectors such as property, healthcare, education, financial services, and e-commerce.
Generally, regulation drives uncertainty, which in turn drives a higher risk premium and potentially the suppression of returns.
Sustainability reporting
Although ESG reporting requirements in China are currently minimal, China has stated its desire to eventually adopt mandatory ESG disclosure requirements. Listed companies have been encouraged to disclose ESG information since 2018. As of mid2020, 1,021 Shanghai and Shenzhen-listed companies published annual CSR/ESG reports, up from 371 companies in 2009. Among larger companies, disclosure is better, with 86% of CSI 300 constituents (the 300 largest and most liquid A-shares) publishing ESG reports in 2020. This positive trend , together with the addition of mandatory disclosure requirements, should help investors to gather higher quality data and better incorporate ESG considerations in their investment process.
Chinese A shares clearly present a rich opportunity set, albeit one that comes with multiple challenges for foreign investors, who are still very much minority participants in China’s domestic stock market.
How does EM ex China compare to EM?
Our analysis of the impact of removing China from the EM universe is based on a comparison of the MSCI EM and MSCI EM ex China indices.
After China, the three largest countries in EM are India, Taiwan, and South Korea. As shown in the figure below, they are the main share gainers in a shift to MSCI EM ex China, accounting for an aggregate 64% of that index compared to their 48% share of the MSCI EM index. When China is excluded, the index weight of North Asia falls from 60% to 47%.
MSCI EM versus MSCI EM ex China – country exposures
As shown in the below figure, on a sector basis, EM ex China has a greater exposure to IT, due to the higher weight of South Korea and Taiwan and, due to the absence of the Chinese internet companies, lower exposures to consumer discretionary and communication services.
MSCI EM versus MSCI EM ex China – sector exposures
China represents a large pool of stocks. As shown in the below figure, excluding China from EM removes securities across the market spectrum but does not change the shape of the index. But it does notably shrink the numbers of very large and very small stocks with the number of index stocks falling from 1,374 to 671; a fall of 51% once China is excluded from EM.
MSCI EM versus MSCI EM ex China – market cap breakdown
Relative performance is significantly influenced by China’s poor performance in the last three years. On a three-year basis to end March 2024, EM ex China has returned 22% per annum compared to MSCI EM’s -5.1%. On a longer time horizon, China has done better. Over 10 years, the annual returns have been 4.2% and 2.9% respectively. And since the end of 2000, the annual returns have been very similar, with EM ex China returning 8.1% compared to MSCI EM’s 7.6%.
Cumulative index performance
What does this mean for investors?
Many investors have been reassessing their approach to investing in China. In part this is prompted by disappointing recent performance and ongoing headlines around US-China tensions and concerns around de-globalisation. The inevitable slowing of Chinese economic growth as the investment-led model that has been so successful over the last two decades reaches a natural limit has also been a factor. Recognising China’s dominant size in EM, some investors have begun to question whether they should have a separate allocation to a specialist China manager rather than rely on a single allocation to an EM manager who includes China. In our view, both approaches have validity. So long as the investor is aware of the pros and cons of each approach, they can make an informed decision that accommodates their own preferences.
ENDS
