China’s Heavy Hand In Emerging Market ETFs

When it comes to emerging market ETFs, two funds stand head and shoulders above the rest in terms of assets: the Vanguard FTSE Emerging Markets ETF (VWO) and the iShares Core MSCI Emerging Markets ETF (IEMG).

Each fund holds $80 billion in assets, and together, they hold over 45% of all emerging market ETF assets. VWO and IEMG have also seen strong inflows this year, gathering $7.1 billion and $9.8 billion, respectively.

Both VWO and IEMG are passive, tracking market-cap-weighted indices. The most significant difference between the two funds is that VWO excludes South Korea while IEMG does not.

In fact, South Korea makes up 13.6% of the portfolio, the third largest country exposure within IEMG. FTSE Russell considers South Korea to be a developed market. It is included in the Vanguard FTSE Developed Markets ETF (VEA).

Strong performance in Korean equities has given IEMG a slight performance advantage, outperforming VWO by about 2.8% over the trailing year.

Hong Kong & China Tilts

One thing these funds have in common is a significant allocation to Hong Kong, making up approximately 30% of the portfolio.

China also comprises a large portion of the portfolio, with a 6.1% allocation within IEMG, and 8.3% in VWO.

Allocations Aren’t As They Seem
However, there are some quirks when analyzing Chinese equities that investors should keep in mind. Publicly traded companies in the People’s Republic of China can fall under several categories.

One type of equity is Chinese A-shares. These shares represent publicly listed Chinese companies that list on Chinese stock exchanges and are quoted in renminbi, China’s currency.

Previously, A-shares were primarily owned by Chinese investors. However, changes in both FTSE Russell and MSCI index construction methodologies mean that both VWO and IEMG now hold allocations to Chinese A-shares.

H-shares are traded on Hong Kong’s exchanges and trade using the Hong Kong dollar, but are regulated by Chinese law. Though they are listed on Hong Kong exchanges, these are Chinese companies. This means that each of these ETFs actually holds a larger exposure to China than it might initially seem. Chinese companies make up anywhere from 30-40% of the portfolio.

This outsized exposure to one country could be a risk for these popular emerging market ETFs. Chinese equities have had a rough year with the government cracking down on the private education industry.

This move has investors wondering whether Xi Jinping’s Communist Party might make further moves to restrict the economy. The iShares MSCI China ETF (MCHI) is down 10.9% year-to-date. (Read: China Internet ETF Halved by Ed Stock Wipeout)

Courtesy of StockCharts.com

In spite of China’s drag on performance, VWO and IEMG are still positive for the year, gaining over 2.5% each. But the extent of China’s negative impact on performance is shown when you consider the strength of Taiwanese equities. Taiwan is the second largest country allocation in each portfolio. The iShares MSCI Taiwan ETF (EWT) has gained 19.7% so far this year.

Other Ways To Play The Space

There are several ETFs that seek a solution to China’s oversized impact on emerging market ETFs. One option is the iShares MSCI Emerging Markets ex China ETF (EMXC).

As the name suggests, this fund tracks a market-cap-weighted index of emerging market equities, excluding China. By excluding China from the portfolio, all other country allocations are increased. Similar to IEMG, this fund includes an allocation to South Korea, making up more than 20% of the portfolio.

Another ETF that excludes China is the Freedom 100 Emerging Market ETF (FRDM).

This ETF tracks an index that selects and weights exposure to emerging market equities based on personal and economic freedom metrics. As the current market environment underscores, China does not currently meet the index’s criteria for civil, political and economic freedom.

The index construction methodology creates a portfolio that looks different from any of the other EM funds covered in this article.

By excluding Chinese equities, both ETFs have done better than traditional market-cap-weighted emerging market ETFs so far this year.

FRDM has outpaced VWO by 3.1% so far, while EMXC is ahead by 5.5%.

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Courtesy of StockCharts.com

Investors who want to maintain an allocation to China but prefer to have more control over the country’s weight in their portfolio might consider pairing one of these ETFs with an ETF like MCHI.

By investing in the country-specific ETF separately, the allocation to emerging markets could be constructed so that Chinese equities make up a smaller portion of the overall allocation, reducing the impact on future returns.

Contact Jessica Ferringer at [email protected]