Should investors adapt their approach to investing in Chinese equities?
Kirsty McLaren - Investment Director, Emerging Market Equities at Schroders
The debate around how investors should allocate to China has grown in recent years. Should they continue to include it as part of a global emerging market (EM) equity allocation, or carve the country out from EM and allocate on a standalone basis?
What is driving the debate around how to allocate to China?
Despite recent market weakness, China is by far the largest component of EM benchmark indices. As of the end of March 2024, it accounted for about 25% of the MSCI Emerging Markets Index; the next biggest markets being India at 18%, Taiwan, 18%, and South Korea, 13%.
Standalone China funds have become more popular with investors, particularly in the last few years since the domestic market became more easily accessible to foreigners.
Today, standard practice is to include China within a global EM allocation. However, more recently, many EM ex China strategies have launched. There are two key drivers behind this:
- China’s size has prompted a desire from some investors to allocate to a specialist manager, while allowing a broad EM manager to focus on delivering ex China returns.
- Asset owners’ desire to take control of their China allocation and therefore China risk themselves.
Benefits to different investment approaches
There are benefits to both approaches, depending on investor objectives and constraints/preferences. The fundamental question is whether the investor wants to retain direct control of their China allocation. Do they have a strong investment view on China? Do other factors drive a need for greater control?
A single allocation to EM including China minimises the costs to the investor in terms of search, monitoring and fees compared to an EM ex China plus standalone China approach. It also unifies risk management across EM equities. However, for a large, sophisticated investor with extensive resources, cost differences are unlikely to be meaningful.
In the end, whether EM ex China plus standalone China is a more expensive approach than a standard EM including China net of fees hinges on two key factors:
- Whether a specialist China manager outperforms a broad EM manager within China (i.e. alpha generation net of allocation effect) over the investment horizon.
- Whether the investor’s decision making in under/overweighting China is superior to that of the broad EM manager.
There is also a third option available to investors with a segregated mandate who are concerned about the dominance of China within EM. They can customise their benchmark and cap the allocation to China.
What does this mean for investors?
Many investors have been reassessing their approach to investing in China. In part this is prompted by disappointing recent performance and ongoing headlines around US-China tensions and concerns around de-globalisation.
The inevitable slowing of Chinese economic growth as the investment-led model that has been so successful over the last two decades reaches a natural limit has also been a factor.
Recognising China’s dominant size in EM, some investors have begun to question whether they should have a separate allocation to a specialist China manager rather than rely on a single allocation to an EM manager who includes China.
In our view, both approaches have validity. So long as the investor is aware of the pros and cons of each approach, they can make an informed decision that accommodates their own preferences.
A historical comparison – Japan’s experience
- Japan used to be part of a single Pacific or Asia Pacific regional equity allocation
- Starting in the 1990s, other Asian markets eased foreign ownership restrictions and began to be
- included in regional benchmarks
- Japan remained by far the largest Asian equity market and dominated regional indices
- The long-term outlook for Japan and the rest of the Asia began to diverge in the 1990s. This was Japan’s lost decade after the 1980s credit bubble burst. It also saw the rise of the Asian tigers
- Demand for Asia ex Japan investment products began to rise with Japan allocations increasingly serviced by specialist managers This is now the dominant approach to investing in the region. For example, Morningstar lists four times as many Asia/Pacific ex Japan than Asia/Pacific inc Japan funds sold in Europe, and in terms of AUM, the ex Japan group is eight times bigger