Emerging Markets ... Without China?

October 01, 2020

[This article appears in our October 2020 issue of ETF Report.]

For many investors, “emerging markets” is synonymous with China—for good reason. China is by far the largest emerging economy; in fact, it’s the second-largest economy in the world, after only the U.S. The Asian country’s presence looms large in market-capitalization-weighted and smart beta strategies alike; roughly a third of all emerging market ETF assets now are invested in Chinese equities.

Yet there are significant risks to investing in China, from concentration risk to valuation concerns. Increasingly, many investors are seeking a more finely tailored approach to the country—if they want exposure to it at all.

32% Average EM Allocation To China
In emerging markets, China exposure is ubiquitous: The average emerging market (EM) ETF (excluding leveraged, inverse and defined outcome ETFs) places about 32% of its portfolio in China stocks. That translates to roughly $72 billion of total invested assets in EM equity ETFs.

Many ETFs have much higher exposures, though. The largest EM fund, the $62 billion Vanguard FTSE Emerging Markets Equity ETF (VWO), puts 44% of its portfolio in China, while the second-largest ETF, the $56 billion iShares Core MSCI Emerging Markets Equity ETF (IEMG), allocates 39%.

Meanwhile, the ETF with the most exposure to China stocks is the $143 million iShares MSCI BRIC ETF (BKF), with a whopping 71% of its portfolio in China (Figure 1).

Risks To Investing In China
However, there are many reasons an emerging market investor might want an ETF that forgoes China equities.

The first is concentration risk. Broad-based emerging market ETFs are supposed to provide diversification, but that’s a tall order when a third of the portfolio (or more) is invested in the equities of a single country—especially when the valuations of said equities can be suspect. The Luckin Coffee delisting from Nasdaq due to fraud is a recent example.

It’s difficult for foreign investors to obtain independently verifiable data about Chinese company performance or fundamentals because the government so tightly controls what investors see.

In fact, Shanghai’s and Shenzhen’s markets often move according to Beijing’s command. For example, in July, when China’s government took out a full-page ad in a securities-focused newspaper, A-shares (as tracked by the XTrackers Harvest CSI 300 China A-Shares ETF (ASHR)) popped 11%.

“Government rhetoric is the only indicator anybody has for what’s going to happen in the stock market in China,” said Perth Tolle, founder of Life + Liberty Indexes. “None of the other data is transparent, or widely available or reliable.”

As a result, some investors prefer to more finely tune their China equity exposure, investing in only the themes or sectors they trust; in which case, an ex-China emerging market ETF can be a vital customization tool.

Meanwhile, for ESG-minded investors, a broad ex-China EM ETF can still offer marketlike exposure without the risk of investing in a country potentially cooking its books or engaging in human rights abuses.

Excluding China
As of Sept. 1, there were four emerging market ETFs that have no exposure to China: the $74 million iShares MSCI Emerging Markets ex China ETF (EMXC), the $19 million Columbia EM Core ex-China ETF (XCEM), the $19 million Freedom 100 Emerging Market ETF (FRDM) and the $2 million KraneShares MSCI Emerging Markets ex China Index ETF (KEMX).

(A fifth, the $14 million Global X MSCI Next Emerging & Frontier ETF (EMFM), also holds frontier stocks; for that reason, we aren’t including it in the following analysis.)

EMXC is the iShares product—and, perhaps unsurprisingly, is the biggest. The fund’s index, which is essentially the MSCI Emerging Markets Index but with China excised, covers roughly 85% of the emerging market universe by market cap.

XCEM is the next biggest (by a hair). Like EMXC, XCEM offers a broad take on emerging markets, just missing China exposure. The ETF, which Columbia acquired in 2016, is the oldest ex-China EM ETF on the market—and the cheapest, with an expense ratio of just 0.16%.

Nipping at XCEM’s heels is FRDM, the only smart beta ETF of the bunch. FRDM uses, selects and weights stocks according to “freedom weighting,” a methodology that evaluates countries based on more than 75 metrics of civil, political and economic freedoms afforded their citizens. It’s also the only ETF of the four that doesn’t specifically exclude China in its investment objective.

Finally, there’s KEMX, which uses the same index as EMXC but charges almost twice as much (0.49% versus EMXC’s 0.25%). From boutique issuer KraneShares, best known for its highly thematic China equity ETFs, KEMX isn’t meant to be used in isolation, but to complement other KraneShares products.

Different Takes, Same Theme
Though three of the four ex-China emerging market ETFs offer the same basic approach—broad emerging market exposure, with China carved out—that doesn’t mean they’re interchangeable (Figure 2).

Interestingly, according to ETF Action’s ETF Overlap Analyzer Tool, there are only 20 stocks common to all four ETFs, out of a total 616 unique holdings. Even KEMX and EMXC, which track the same index, only share roughly 64% of their portfolios. The discrepancy arises from the fact that EMXC holds hundreds more stocks than does KEMX (Figure 3).

As such, the four ETFs have differed widely in their returns. FRDM is the clear outperformer, having dropped the least year to date; it’s down 6%. (It’s up 7% over a 12-month basis, however.)

Meanwhile, XCEM lags behind, with an 11% drop year to date and just a 1% gain over the past year (Figure 4).

Freedom Weighting: Secret Sauce?
So why is FRDM the standout? It comes back to that freedom-weighting, which avoids not just China but any country with markets and a citizenry that rank as less free.

Therefore, while FRDM possesses a hefty allocation to Taiwan (26%) and South Korea (22%), similar to its competitors, the fund breaks away by forgoing exposure in Brazil and Russia, which comprise anywhere from 14-17% of the other ETFs’ portfolios.
In addition, at 3%, FRDM’s allocation to India is substantially smaller than the other ETFs, which all have roughly 14% allocated to the country.

Instead, FRDM is bolstered by a significant allocation to Poland (16%) and Chile (15%)—countries that have their own problems, but that still rank more highly than their peers.

Lagging Performance
It’s worth remembering, however, that all four ex-China emerging market ETFs exhibit worse performance than emerging market funds that do allocate to the country. VWO, for example, has returned 2% year to date, and is up 15% on a one-year basis—almost double FRDM’s return.

Performance isn’t everything, however—especially if you don’t or can’t necessarily trust the numbers coming out of China. As with all investments, you should consider the risks carefully before investing in an emerging market fund, whether it holds China stocks or not—especially if an autocratic regime is involved.

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