Avoiding China Has Been a Winning Investment Strategy. But It Isn’t Easy.

Workers sort out parcels at a distribution center for e-commerce platform JD.com in Beijing. (AP Photo/Ng Han Guan) (AP)
Workers sort out parcels at a distribution center for e-commerce platform JD.com in Beijing. (AP Photo/Ng Han Guan) (AP)

Summary

Chinese stocks have diverged from the rest of the emerging markets, but the country is still weighing heavily on other economies.

Investors in emerging-market stocks have profited this year by staying away from China.

The MSCI China Index is down 8% this year through Nov. 15, while a broader emerging-markets benchmark that excludes China has risen 8% over the same period. Chinese stocks have been weighed down by the country’s shaky economic reopening, a pullback by foreign portfolio managers and an increasing reluctance among the country’s small investors to buy stocks.

The large divergence in performance, and geopolitical tensions between the U.S. and China, have fueled a drive toward exchange-traded funds that exclude Chinese stocks. BlackRock’s iShares ETF that tracks the MSCI Emerging Markets ex China Index has more than doubled in size this year to $7.6 billion as of this week. A few other ETFs that offer similar strategies also have doubled their assets under management.

The Thrift Savings Plan, which holds the retirement savings of U.S. federal employees and members of the uniformed services, has a large international stock fund that will shift to tracking a global MSCI benchmark that excludes China and Hong Kong. The international index fund has $68 billion from plan participants and will make the transition next year, the Federal Retirement Thrift Investment Board said this week.

But can investors really cut their China exposure completely?

Many analysts and portfolio managers are skeptical about the avoid-China strategy, in part because of the enormous gravity the world’s second-largest economy pulls in Asia and around the world.

China’s importance to other emerging markets also means a bounceback in its economy would be felt widely. But portfolio managers say those who take a dim view of the country’s prospects should consider how else they might hedge against China’s market malaise. Here are a few reasons why.

China’s problems are everyone’s problems

China makes up around 30% of the MSCI Emerging Markets Index, which has gained 2.8% this year through Nov. 15. But even when the country is removed from this and other global indexes, investors are still exposed to China’s economy—and its political currents.

“I don’t know if EM ex-China is something that really exists…It is still very, very exposed to China," said Hicham Lahbabi, deputy head of Asia ex-Japan equity at Amundi, an asset-management company.

Taiwan is an extreme example. The self-governed island has a weight of more than 21% in the MSCI Emerging Markets ex China Index as of October and is highly exposed to mainland China. Taiwan is often talked about as a flashpoint of a possible military conflict involving China and the U.S., its giant chip manufacturers risk being caught up in tensions between the world’s two superpowers, and it relies on the mainland for about a fifth of its trade.

China’s economic clout means it is a crucial trade partner for countries across the world. This is particularly true of emerging economies, where Beijing has steadily built up economic and political ties. It is the largest source of demand for exports from Brazil, South Africa and South Korea, according to the World Bank’s latest available data. These countries are all a big part of the MSCI Emerging Markets ex China Index.

It isn’t just emerging markets: China is also one of the biggest trading partners of the U.S., although the numbers are declining.

The professionals aren’t ready

There are also technical hurdles for investors who want to insulate themselves from Chinese market volatility. Unless individual investors are going to pick their own stocks, they need to trust others to look after their money—either active managers or passive funds, including ETFs. The vast majority of emerging-markets stock funds hold shares of Chinese companies.

Emerging-market investors who only want to put money into funds that exclude China have relatively few products to choose from at present. They would be cutting their options by more than 90%, said Michael Kelly, a portfolio manager at PineBridge Investments. He said asset-management companies would eventually fill the gap, but it will take time.

“We’re still at the early stages of eventually seeing an EM ex-China adoption because it sounds like clients have been interested, but the product offerings are not as diverse," said Kelly.

Investing in emerging markets without Chinese stocks is a relatively new strategy. The MSCI Emerging Markets ex China Index was launched in 2017, almost three decades after the broader benchmark was created.

Where else do you put your money?

Investors who want to buy Chinese shares can do so in the U.S., Hong Kong or mainland China itself, including through stock-trading links that make it relatively simple for international investors to bet on Chinese stocks. That gives investors a lot of choice.

The value of Chinese companies listed on the Shanghai and Shenzhen stock exchanges was more than $11 trillion at the end of September, according to figures from the World Federation of Exchanges. There are several more trillions of dollars of mainland Chinese shares listed in Hong Kong and on U.S. stock exchanges.

No other emerging market offers this sort of scale. The total value of stocks listed on India’s National Stock Exchange was about $3.6 trillion in September. South Korea’s stock exchange had a total market capitalization of around $1.7 trillion. Brazil’s was worth $850 billion.

The fact that these markets are smaller than China’s means it is more likely that investors will end up concentrating on the same pool of stocks. That will make it harder for investors to beat the wider market, said fund managers.

It also means investors may find it hard to diversify away from certain big themes, even when they spread their money between different countries. For example, investors who choose to shift money from China and put it into Japan, South Korea, Taiwan and India—some of the biggest stock markets in Asia outside of mainland China and Hong Kong—would be taking a big bet on technology, said Kunjal Gala, head of global emerging markets at Federated Hermes.

“You will be hostage to the chip cycles and the handset-replacement cycles," he said.

Write to Weilun Soon at weilun.soon@wsj.com

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