China Syndrome

William Ehart

INDEX DESIGNERS FTSE Russell and MSCI are jumping on China’s A train this year—and index-fund investors should watch out. There’s a $6 trillion wild-and-woolly domestic Chinese stock market slowly chugging your way, whether you like it or not. Yes, it may bring riches—and it’ll definitely bring huge risks.

In fact, your emerging markets index fund may already have 34% in Chinese stocks, and it could exceed 50% in years to come. Sound unnerving? For those with a position in an emerging markets index fund—or are considering one—good alternatives are hard to come by.

As HumbleDollar’s Adam Grossman noted in March, MSCI bowed last year to Chinese pressure to increase representation of Chinese stocks in its emerging markets indexes. The increased weight is being given to China’s so-called A shares, a $6 trillion stock market—second in size only to the U.S.—that once had strict limits on foreign investment. A good thing? Even as China has eased ownership restrictions, foreign investors have voiced concerns about liquidity, transparency, accounting standards and levels of state ownership.

As you read this, the two main iShares emerging markets ETFs, which have nearly a third in Chinese stocks and which track MSCI indexes, are adding to their China stake. Their holdings of A shares have been growing this year in a step-by-step process. The next step is this month and the last—for the time being—will be in November. Pressure from Chinese authorities for greater ownership will likely continue.

Now, FTSE Russell—some of whose benchmarks are followed by Vanguard Group’s international funds—has gotten on board. It began adding A shares in June, and will add a little more in September and even more in March 2020. The company promises at each step along the way to gauge the impact on markets. It noted that, in the years ahead, China could make up more than half of its FTSE Emerging Markets Index.

China is already 34% of the Vanguard Emerging Markets ETF (VWO) and its sister mutual fund, which track the FTSE Emerging Markets All Cap China A Inclusion Index. One reason China is such a big part of the Vanguard funds: FTSE no longer considers South Korea an emerging market, so that’s one less country in the index.

MSCI, meanwhile, still counts South Korea as a developing market. For now, China comprises 32% of the iShares MSCI Emerging Markets ETF (EEM), which tracks the main MSCI Emerging Markets Index. The slightly different—and much lower cost—iShares Core MSCI Emerging Markets ETF (IEMG) has just 29% in China. It tracks a broader index that includes more mid- and small-cap stocks. Its China exposure will rise, too.

Currently, most foreign ownership of Chinese companies is focused on stocks that trade in the U.S. or Hong Kong. The latter are so-called H shares, denominated in Hong Kong dollars. By contrast, the A shares trade in yuan, the Chinese currency, in Shanghai and Shenzhen. Buying and selling is dominated by Chinese retail investors, who have a reputation for short-term focus.

Of course, this new market could be a great opportunity for foreign investors. Just remember that China is trying to keep its economy and state-owned enterprises afloat. The A shares are chock full of companies part-owned by the government. The revamping of emerging markets indexes is a multi-billion-dollar windfall for Chinese shareholders, including the government and high-ranking Communist Party members, with the money sucked from other countries as index funds reallocate their assets.

What if you want more in emerging markets, but not so much in China? Buying funds that focus narrowly on other regions and countries would add complexity and risk to your portfolio. Meanwhile, the more diversified alternatives aren’t compelling and fund expenses tend to be much higher.

Given that the issue here is the market-capitalization weighting of Chinese companies, is fundamental indexing the answer? Do funds that weight investments by other factors, such as quality, dividend or lack of volatility, avoid excessive exposure to China? Not necessarily. For instance, Invesco FTSE RAFI Emerging Markets ETF (PXH) has 33% in China.

One well-regarded alternative is iShares Edge MSCI Minimum Volatility Emerging Markets Index ETF (EEMV), with a somewhat lower 27% in China. But the fund has a heavy overweight in utilities and communication services, and an underweight in technology. In addition, its exposure to China likely will rise along with that of the MSCI indexes.

With other fundamental ETFs, you may find yourself jumping from the frying pan into the fire. For instance, the WisdomTree Emerging Markets High Dividend ETF (DEM), Schwab Fundamental Emerging Markets Large Company Index (FNDE) and iShares Emerging Markets Dividend ETF (DVYE) have between 16% and 18% in Russia. Russia’s economy and capital markets, under the kleptocratic rule of Vladimir Putin, have earned just a 4% weighting in the broad emerging market indexes, so these three fundamental ETFs quadruple Russia’s impact.

Russia remains under Western sanctions for its illegal annexation of Crimea from Ukraine in 2014 and, of course, there are ongoing concerns about its meddling in U.S. and other foreign elections. But such factors and the associated risks may be fully priced in. According to Yardeni Research, the Russian market’s price-earnings ratio is just 5.4 based on expected earnings, versus 17.7 in the U.S., 11.3 in China and 12.2 in emerging markets generally.

There are a few ETFs tailored to those trying to limit exposure to things like state-owned enterprises, China itself or authoritarian regimes in general, but they have limited trading volume. Take the WisdomTree Emerging Markets ex-State-Owned Enterprises ETF (XSOE). It has 34% in China and 5% in Russia. WisdomTree notes that—because the fund excludes companies more than 20% owned by governments, which often are financial or energy companies—it has a higher weighting in those with less traditional state ownership, such as technology firms and companies that cater to consumer discretionary spending.

There are two other alternatives you might check out, but they’re in their infancy and have limited assets. First, there’s iShares MSCI Emerging Markets ex China ETF (EMXC). Net assets of this two-year-old fund are just $29 million. The fund is reasonably well diversified, with 17% in South Korea, 16% in Taiwan, 12% in India and 12% in Brazil.

Second, you might investigate Alpha Architect Freedom 100 Emerging Markets ETF (FRDM). This fund was launched June 30 and has less than $12 million in assets. It owns no China or Russia, and also no Brazil. Instead, some 70% of the fund is in Taiwan, South Korea, Poland and Chile.

William Ehart is a journalist in the Washington, D.C., area. Bill’s previous articles were Before the FallNo A for Effort and Father Knew Best. In his spare time, he enjoys writing for beginning and intermediate investors on why they should invest and how simple it can be, despite all the financial noise. Follow Bill on Twitter @BillEhart.

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