Split decision: Should investors separate China from EM equities?

Many investors are contemplating whether to separate China from the rest of their emerging market (EM) equity allocation. The case for separation is generally based on China’s growing weight in broad EM benchmarks. We believe, however, that the key decision point is not China’s dominance of the EM index, but the extent to which a standalone China equity allocation can be viewed as similar to an EM ex-China equity allocation. If they are, in effect, the “same thing,” then the relative size of one to the other makes no practical difference.

With this in mind, we evaluated the similarity of the two allocations, using the MSCI China Index and the MSCI EM ex-China Index as proxies. Of course, no two countries/regions will ever be exactly the same, so our focus was on the degree of similarity and whether it is changing over time. We also used a variety of metrics to gauge similarity, recognizing that some may change more than others and that investors will weigh their relevance differently depending on their asset allocation approach.

In summary, we found that the case for separate China and EM ex-China allocations is:

• Strong if the decision is based on factors or return drivers
• Growing if the decision is based on economic (sector) composition
• Supportive if the decision is based on co-movement metrics
• Inconclusive if the decision is based on risk and return metrics

In this paper, we discuss these findings in detail and also touch briefly on practical considerations for those establishing separate China and EM ex-China allocations, including the challenge of a limited universe of EM ex-China strategies…

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