Geopolitical concerns and disappointment about returns have prompted institutional investors to explore emerging market (EM) equity ex-China strategies, according to bfinance.

“We have had quite a few discussions with pension funds and other clients on this topic,” said Weichen Ding, responsible for equity manager selection at the London-based consultant.

“There could be immediate action soon. Some of our clients are likely to shift money to EM equity funds and mandates that exclude China,” he said.

But this does not necessarily mean that these clients will divest completely from China, which now comprises 30% of the MSCI Emerging Markets Index.

Some of them already have dedicated China exposures and want to more clearly separate their Chinese investments from the rest of their EM exposure, according to Ding.

Asset managers are anticipating the growing interest in China-less equity strategies by launching new funds.

Among nearly 250 EM equity managers recently surveyed by bfinance, 45 are currently managing active EM ex-China portfolios, and nearly one hundred additional managers are considering new mandates in this space.

“Several are already running portfolios, whether with internal money or on paper, to develop track records ahead of expected client demand,” Ding said.

Weichen Ding (photo)

Weichen Ding at bfinance

Political risk

Ding sees three reasons for investors to consider cutting out China from their existing EM exposure. The most obvious one is risk management. The increasing tensions between China and the west over the past few years have made China a more risky place to invest.

“Some investors may at some point have to divest from China, and they need to be prepared for that. It’s easier to divest if you have all your Chinese investments concentrated in a separate portfolio,” Ding said.

“That also makes it easier to control your China exposure. If you invest only via a global EM equity fund or mandate, you can’t really tell the manager to invest only up to a certain percentage of assets in China. That should be for the manager to decide. But investors can easily dilute their exposure to China by blending their existing global EM equity exposure with a new ex-China manager,” he added.

Chinese equities underperform

Chinese equities have vastly underperformed other emerging markets over the past three years and as such have been a significant drag on overall EM performance.

Over the past three years, EM ex-China has significantly outperformed Chinese equities, posting a return of close to 10% while the performance of both Chinese A-shares and Hongkong-listed stocks has been deeply negative (-14%).

Chinese equities have continued to bleed this year: while the MSCI Emerging Markets ex-China Index is up about 7% year-to-date, Chinese equities are down by more than 13%.


Another reason to consider cutting China out of general EM allocations is that the correlation of the Chinese equity markets with the rest of emerging markets has been steadily coming down in the past three years, from 0.8 to 0.4.

“This is a direct result of deglobalisation and of efforts to reduce dependency on China in supply chains. Western countries now rely more on places like India and Vietnam. China is also focusing more on domestic, consumption-led growth,” said Ding, who expects this trend to continue.

“Going forward, I expect other EMs to be more correlated with western markets than with China. As a result, China and the rest of EM may be viewed as increasingly complementary in a portfolio context.”

The share of China in the MSCI Emerging Markets Index has grown to 30% in the last few years. This increasing dominance has seen active managers overlook attractive stocks in smaller EM countries and/or at smaller capitalisation sizes, according to Ding.

An ex-China portfolio would free up space to select such stocks, as managers will work with a different benchmark going forward, which does not anymore include big Chinese firms such as Ping An, Alibaba or Tencent.

“As such, an EM ex-China manager may be better equipped to provide exposure to attractive opportunities in smaller markets,” Ding noted.

So far, however, the EM ex-China market remains a niche. Assets under management of the 45 strategies that are currently live total some $8bn, with the median strategy having a mere $10m in assets under management (AUM). In addition, only eight strategies have a track record of more than three year.

“Few managers have proven they can build robust portfolios without China stocks,” concluded Ding.

Median quoted fees for EM ex-China mandates can go as low as 64 basis points, according to bfinance. For EM including China this figure similar. But as asset managers want to set up an asset base, “early bird and seed investor discounts provide significant opportunities for highly competitive fees,” according to the consultancy.

“Allocators casting a broad net can identify a large number of managers that are looking to enter the space or build AUM, creating good scope for negotiating attractive terms,” Ding said.

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