- The U.S. and China represent two of the largest and complementary global-equity markets.
- Home-biased investors in China may neglect long-term growth and diversification opportunities through a lack of consideration of foreign equity exposure.
- A hypothetical portfolio representing a simple fixed-weight combination of the MSCI China A 50 Connect and MSCI USA 50 Indexes achieved a tradeoff between risk and other characteristics.
This year has been characterized by increasing geopolitical tensions, rising inflation and monetary tightening around the world. For Chinese investors, COVID-19 lockdowns, increasing volatility of the Chinese yuan and concerns about economic decoupling may also have implications for asset-allocation strategies.
Amid this backdrop, outbound investing has been an increasing trend in China. The qualified domestic institutional investor (QDII) quota, the only scheme available to Chinese investors to invest in offshore markets, rose 35% in 2021.1 Our focus in this blog post is Chinese investors — who are considered home-biased since they allocate around 95% of their equity investments in China2 — and the potential opportunities and risks inherent in global investing.
US and China: The largest economies and equity markets
For Chinese investors who have not implemented global investing on a full scale, it’s worth noting that the U.S. and China represent two of the largest economies and equity markets. Due to their historically complementary exposures, they may also represent divergent growth opportunities.
Looking at the exhibit below, we see that the U.S. and China contributed 14% and 28%, respectively, of the five-year global real GDP growth. Meanwhile, the U.S. and China weights of the MSCI World Index and the MSCI Emerging Markets (EM) Index have represented an outsized contribution over the past decade, representing 69.7% and 31.3%, respectively.
GDP growth contribution and weight
Calculation based on IMF, WEO databases. Data as of April 2022. Index weight data as of Sept. 30, 2022.
Complementary market exposures and diversification opportunities
The historical return correlation between the U.S. and China from January 2012 to September 2022 was about 46%, below the average correlation of markets in the MSCI World Index during the same period. A few reasons for this relatively low historical correlation were the differences in the policy objectives and growth drivers of these two economies, as well as their economies and equity markets being in different stages of development.
The exhibit below shows that the MSCI USA Index had higher exposure to the information technology and health care sectors, while MSCI China and China A were dominated by consumer discretionary, communication services, industrials, consumer staples and materials. From a thematic lens, the U.S. market provided exposure to newly-emerged themes that were missing in China, such as blockchain and cybersecurity. For themes like future mobility, China and the U.S. cover the global leaders in the value chain. Chinese companies also source revenue mainly from the domestic market, while the MSCI USA Index generated only 60% of its revenue from its home base.
Sector, economic and thematic exposure varied across the US and China
Data as of Sept. 30, 2022.
Case Study: Managing US and China exposures within a single portfolio
In this case study, we assess diversification effects by using the MSCI China A 50 Connect Index and the MSCI USA 50 Index to construct a hypothetical mega-cap USA/China portfolio.3 We chose these as building blocks given that the MSCI China A50 Connect and MSCI USA 50 Indexes covered 40% to 50% of the market cap and profit of their corresponding parent indexes, as well as a significant share of risk in the MSCI USA Index and the MSCI China A Index, as shown in exhibit below.
Historical risk contributions
We simulated scenarios of combined China/USA indexes with fixed-weight allocation to the MSCI China A50 Connect Index and the MSCI USA 50 Index to evaluate the potential tradeoff between portfolio risk and other outcomes such as earnings-per-share (EPS) growth, carbon intensity and revenue sources.
The exhibit below shows a hypothetical portfolio with a 100% China allocation that derives 80% of its revenue from its domestic market, 19.5% EPS growth and 295 tons of carbon emissions per USD 1 million in sales. The portfolio reached minimal ex-ante total risk of 18.9% at 40% China A and 60% U.S. allocation, where 39.3% of the revenue came from China, 32.9% from the U.S. and 27.8% from rest of the world. EPS growth was 15.6%, and carbon intensity was 166.1tCO2e/USD 1 million of sales.
Efficient frontier of a China/US mega-cap portfolio
Total risk is calculated based on MSCI Barra Global Equity Model (GEMLT) as of Sept. 30, 2022.
1State Administration of Foreign Exchange, June 2022.
2Kleintop, Jeffrey, “Why Invest Internationally?” Charles Schwab, Feb. 14, 2022.
3The MSCI China A 50 Connect Index is constructed from the MSCI China A Index (the parent index). It aims to reflect the performance of the 50 largest securities representing each Global Industry Classification Standard (GICS®), sector and reflecting the sector weight allocation of the parent index. GICS is the global industry classification standard jointly developed by MSCI and Standard & Poor’s. The MSCI USA 50 Index is constructed from the MSCI USA Index, selecting the largest 50 securities in the parent index by their free float market capitalization.
Further Reading
MSCI China A 50 Connect Index: One-Year Anniversary
China at a Crossroads: Three Scenarios for Investors
How Diversified Are US Equity Investors?