American pension funds have become embroiled in the cold war between the US and China and diversification strategies may be affected by the new scrutiny of investments in Chinese companies.

This scrutiny is a bipartisan effort. Not only does the Trump administration want to curb Chinese companies’ ability to raise money from American investors, Democratic legislators agree with a tougher stance toward Beijing after the COVID-19 pandemic.

In May, the Senate passed bipartisan legislation that would kick Chinese companies off US stock exchanges unless their audits are inspected by US regulators. A version of the legislation was introduced in the House of Representatives by the Californian Democrat Brad Sherman and it may become law before the November presidential election. Then Chinese companies – that have never given access to audit records needed to review the quality of financial accounting – would have three years to comply with inspection requirements or face delisting from the Nasdaq or NYSE.

These new rules will clearly affect the composition of equity indices and the investment strategies. Yet even before that, indices that include Chinese companies have become problematic for pension funds.

The first fund grappling with this dilemma was the $400bn (€354bn) California Public Employees’ Retirement System (CalPERS). In March, US national security advisor Robert O’Brien said that the Trump administration was examining CalPERS investments in Chinese military companies. “Some of the CalPERS investment policies are incredibly concerning,” O’Brien said. “We’ve got folks who are going to rely on their pension for their retirement and putting those investments into companies that don’t have the same reporting requirements that American companies do is scary.”

A CalPERS spokesperson explains: “CalPERS invests in international stocks using two well-established indices: the MSCI and the FTSE. In 2019, the FTSE and MSCI modified their respective indices to include China A-shares, thereby increasing their exposure to Chinese equities. CalPERS rebalanced its portfolio in light of these changes accordingly, resulting in the removal of 143 stocks and the addition of 198 stocks. Nearly half of the companies added were Chinese companies because of the MSCI and FTSE indices’ changes.”

Robert O’Brien

The spokesperson points out that Treasury’s Office of Foreign Assets Control (OFAC) is responsible for blocking certain investments to protect national security. “CalPERS takes these restrictions very seriously, thereby operating in full compliance with OFAC’s rules.

“Accordingly, and critically, CalPERS does not have any holdings in any company that OFAC has blocked from investment.”

Indices increase exposure
The index providers themselves must develop indices that only include companies allowed by OFAC. But that is not enough for critics of Chinese investments, as the $594bn Thrift Savings Plan (TSP) can illustrate.

TSP is a defined contribution (DC) plan which offers simple investment choices among low-cost index funds for all US federal government employees. One of the options available is the $54bn International Stock Index Investment (I) fund that tracks the MSCI EAFE (Europe, Australasia, Far East) index.

In 2017, the TSP board decided to shift the I Fund benchmark to the MSCI ACWI ex-US Investible Market index that was made up of about 8%  Chinese companies, as of 30 September 2019, according to an Aon Hewitt Investment Consulting study. The new policy was set to start in June 2020, but this May it was halted by a letter that labor secretary Eugene Scalia sent to Michael Kennedy, chairman of the Federal Retirement Thrift Investment Board (FRTIB). He said: “At the direction of President Trump, the board is to immediately halt all steps associated with” the I Fund shift. 

Scalia said the Trump administration planned “to reverse its decision to invest plan assets on the basis” of the MSCI ACWI ex-US IMI index.  He justified the action in relation to “national security and humanitarian concerns for the United States”. So the FRTIB voted unanimously to pause the transition.

Steven Schoenfeld

The problem for all pension funds is China’s growing weight in the main emerging market indices, according to Steven Schoenfeld, the founder and chief investment officer of BlueStar Indexes. He estimates that the 30 largest US public pension plans have more than $150bn in emerging market equities, of which more than $50bn is invested in Chinese companies. 

“Last year the EM indexes of MSCI, FTSE Russell, and S&P Dow Jones increased their allocation to China to 34% to 37%,” Schoenfeld says. 

“Pension funds must be aware that using these indexes means taking many risks, including the possibility of interference from Beijing, given that most listed Chinese companies involve a degree of state control and the reputational risk from Chinese companies with low ESG ratings.” 

He says he was more convinced than ever given the substantial deterioration in US-China relations: “That this issue will be a major challenge for public and private pension funds for the remainder of this year and beyond.”