China – from emerging market to dominant force

Over the last 20 years, China has grown to be the second most dominant force in the world behind the US, with its share of global GDP now at around 20% according to the IMF, although some may argue it’s already ahead of the US on other measures. Despite this phenomenal growth, from an investment perspective the country continues to be relatively lightly-owned directly, with investors gaining their exposure indirectly through broader exposure to Asia or the emerging markets.

While that has worked well up to now, the reality is that, such is the size of China and its related markets such as Hong Kong and Taiwan, they are now dominating the performance profile of the broader regional indices that include them. In its last update in June, MSCI data showed that China and Taiwan combined now accounted for over 53% of its MSCI Emerging Markets index, while they also account for 52% of the MSCI AC Asia Pacific ex Japan index. With the overlap now so high between the two indices, the correlation between them is running at 0.96 over the past five years, meaning there is little diversification benefit from allocating to both parts of the market and, even within that, China is the dominant force as to what happens to that benchmark. More recently, we have seen the inclusion of China A shares to the emerging markets benchmark, with the allocation increasing to over 4%. This is with an inclusion factor of just 20%, which indicates that there is much more scope for this to rise much further should the Chinese authorities address the concerns of investors in respect of the operation of their capital markets. Recent analysis from Allianz Global Investors suggested that China A shares alone would account for 27% of the MSCI Emerging Markets index if a 100% inclusion factor was used.

So where does this leave us? In my view, the dominance of China and Hong Kong in these benchmarks is now so great that it is sensible to investigate the potential for ‘ex China’ benchmarks. Much as we have treated Japan separately from Asia in most asset allocations for many years, there is a strong argument that China should be treated in the same way. If we look at the MSCI AC World index, Japan currently accounts for just under 7%, while China is just over 5% – which would certainly be sufficient to justify an asset allocation in its own right in investors’ portfolios. However, this has to be led by the index providers, as few asset managers will be brave enough to launch Asia or emerging markets funds that exclude China, despite some mentioning off the record in our discussions that this would be a sensible move.

When looking at the ETF market, a quick search for anything ‘ex China’ brings up one lonely MSCI Emerging Markets ex China ETF from Lyxor that launched last year, showing that we have a long way to go before this is a real investment possibility for all. Of course, there are single-country ETFs that focus on China, but that doesn’t address the benchmark issue.

However, this is something we have looked to embrace on the AJ Bell Active MPS this year, with a dedicated China A share allocation being added to our highest-risk growth portfolio in February. As we have seen, China is well represented in traditional benchmarks, but the A share market remains a small allocation, meaning that a dedicated allocation brings useful diversification, with access to nearly 4,000 companies listed and over 700 in the index. This is nicely illustrated when looking at the correlation of the MSCI China A Onshore index with the traditional Asia and emerging markets indices:

Source: Financial Express, 10-year correlation to 13 October 2020 in GBP.

While it is easy to think of domestic China being full of high-risk small caps, around 70% of the benchmark has a market cap of over £8 billion. Compare this to the FTSE 100 index, where the smallest company currently has a market cap of around £4.3 billion, and it tells us that the vast majority in this market are large, established companies.

The allocation in our MPS has been implemented using the hugely experienced team at Allianz via its China A Shares fund and, while the UCITS fund was only launched two years ago, the team has been investing in A shares for over a decade and has $7 billion in the strategy. While the opportunity set is wide, the team’s approach is very focused on the best quality growth companies and, as a result, the portfolio is concentrated with between 50–70 positions.

While the position has only been in the portfolio a few months, it is already proving its worth, with the China A shares market performing strongly. Looking ahead, the direction of travel is clear, with the dominance of China only likely to increase. As a result, it is highly likely that we will be looking to add more dedicated China exposure to the portfolio in the coming months. We only hope that the benchmark providers recognise how the market is changing and bring more choice to investors to once again allow allocations to Asia and the emerging markets to bring genuine diversification to a portfolio alongside dedicated China exposure.