Red Flags

William Ehart

CHINA’S CRUSHING of Hong Kong’s independence is just the latest aggressive move to raise my hackles—and make me question the wisdom of investing there, as well as in much of Asia. Which puts me in a tough position, since the Pacific Rim represents nearly 70% of the emerging markets indexes.

I hear you saying that politics shouldn’t factor into investment decisions. True, if returns are your only consideration, political and moral issues don’t belong in the conversation. But I believe values have a role to play, though we should also be aware that avoiding or limiting exposure to certain companies, sectors or countries may harm diversification and hold back returns.

In this case, I’m willing to take my chances. I modestly reduced my emerging markets exposure in early May, even before the subjugation of Hong Kong. I don’t want to avoid developing markets altogether, nor could I, without blowing up my portfolio of primarily index and target-date funds. Instead, I’ve managed to cut my stock allocation in emerging markets to a level somewhat below their weight in world markets. (I don’t mind the reduced exposure to Russia, Saudi Arabia and increasingly authoritarian Brazil, either.)

What precipitated this? Have I not been trying to build a set-it-and-forget-it portfolio?

I was shocked to discover recently, when I checked via Morningstar’s Instant X-Ray feature, that the Fidelity Freedom 2030 Fund in my 401(k)—my biggest holding—had 10% of its stock allocation in emerging Asia, versus that region’s 6% weighting in the world index. (The fund is actively managed; Fidelity’s target-date index funds are not available in my plan.) That disparity strikes me as a big bet for someone 10 years from retirement, and the opposite of my preference.

Exposure to other Asian economies like Taiwan and Korea comes on top of that. (Index keepers differ on whether Korea is an emerging market. Morningstar puts both it and Taiwan in the developed category.) They represent another 5% of the Freedom 2030 fund’s stock position.

It would be a big risk to avoid or sharply underweight China—which is the world’s second largest economy—or, indeed, the entire emerging markets asset class. That would smack of ego, as if Bill Ehart alone understands the investment risks involved, the nature of the Chinese regime and the chances of a confrontation with a distracted, internally divided U.S.

On top of that, for those of us who want a simple portfolio of broadly diversified funds, there are few good ways to reduce China exposure without slashing emerging markets generally. The country now represents 43% of the FTSE benchmark—the index tracked by the Vanguard Emerging Markets Stock Index Fund—and 37% of the MSCI index followed by the iShares Core MSCI Emerging Markets ETF.

If you own one of those funds, you could replace it wholly or in part with the iShares MSCI Emerging Markets ex China ETF. But the three-year-old fund has just $40 million in assets and average trading volume under 20,000 shares. Taiwan and Korea comprise 40% of the fund, followed by India (13%), Brazil (8%), South Africa (6%), Russia (6%) and Saudi Arabia (5%).

The upshot: Any effort to limit exposure to China and its Pacific neighbors, while maintaining a substantial emerging markets position, results in huge overweights in other emerging countries.

My own approach, to date, has been to take a modest chunk out of my overall emerging markets exposure, so that my holdings are a shade below that of emerging markets’ importance in the overall global stock market. I accomplished this in two ways.

First, I sold part of my target-date position in my 401(k). I put the proceeds, in similar proportion to the target fund, into a total U.S. stock market index fund, a developed foreign markets fund and an intermediate-term bond fund.

Second, I sold WisdomTree Emerging Markets SmallCap Dividend Fund in my IRA and folded the proceeds into the developed market WisdomTree International SmallCap Dividend Fund that I already owned.

It is, of course, my right to invest according to my values, and it’s my obligation to use my judgment. But I can never forget that what I see as judgment may just be the voice of my ego telling me yet again that I know more than everybody else.

That’s why my allocation moves have to be within limits. If I’m wrong, I’m only a little wrong. All-in or all-out approaches are where we get our heads handed to us. But the outsized China position in my target-date fund—and my refusal to accept it—has added hassle to what I hoped would be a hassle-free portfolio. Time will tell if the extra work is worth the effort.

William Ehart is a journalist in the Washington, D.C., area. Bill’s previous articles include Averting My GazeIn and Out and April Fool. 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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