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As China’s role on the world stage continues to loom larger, many investors are contemplating whether to separate the country from the rest of their emerging markets (EM) equity allocation. Most arguments for such separation are based on China’s fast-growing weight in broad EM equity benchmarks, but it’s not necessarily that simple. Let’s take a closer look.
The answer? It depends
We believe the key decision point here should not be China’s dominance of the EM indices, but rather, the extent to which a stand-alone China equity allocation can be viewed as similar (or dissimilar) to an EM ex-China equity allocation. If they are, in effect, more or less the “same thing,” then the relative size of one to the other will likely make little to no practical difference. As we see it, this view on similarity (or lack thereof) depends primarily on the lens being applied.
With that in mind, we evaluated the degree of resemblance of the two equity allocations using two widely followed market benchmarks, the MSCI China Index and the MSCI EM ex-China Index, as proxies. Figure 1 highlights the results for the set of lenses we selected and applied. In summary, we found that the case for having separate China and EM ex-China allocations is:
- Strong if the decision is based on factors or return drivers
- Growing if based on economic sector composition
- Supportive if based on co-movement metrics (e.g., correlation)
- Inconclusive if based on realized risk and return metrics
FIGURE 1
Practical considerations
From a practical portfolio standpoint, one challenge for investors who wish to have separate China and EM ex-China equity allocations is the small field of EM ex-China strategies available to choose from. While this could change going forward, currently investors are limited to either passive implementation or active strategies with relatively short track records.
We believe one potential solution to this problem is to pair a broad global EM (GEM) equity allocation with a satellite China allocation. This approach not only preserves the ability to access a vast universe of active GEM strategies (versus a small universe of EM ex-China strategies), but it also allows for a larger allocation to China equity than that implied by a GEM index. In fact, based on our research on the optimal size of a China allocation in client portfolios, we believe investors should consider a larger-than-benchmark exposure.
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