China’s large share in the MSCI Emerging Markets Index and its declining correlations with emerging markets (EM) may indicate that the two universes could be treated as separate allocations.
The MSCI Emerging Markets ex China Index represents an investable opportunity set and has country, economic and sector exposures distinct from the MSCI Emerging Markets and MSCI China Indexes.
Derivatives overlays could be used to adjust active allocations to EM and EM ex China in lieu of liquidating or transitioning positions in an underlying pool of funds.
China’s market-cap share of EM equities has grown steadily over the last decade. In 2008, it made its first appearance as the largest weight (15%) in the MSCI Emerging Markets Index. After holding pole position almost every year since, it reached an all-time high of 43% in 2020. As of Oct. 31, 2023, China’s weight in the index was 30%, nearly Taiwan and India’s combined weight.
In recent years, EM ex China’s return correlations with China have fallen, suggesting fewer economic interdependencies.
China’s falling correlation with EM over the last decade
The analysis period is from January 1999 through October 2023. Correlations are shown for the MSCI China Index with the MSCI Emerging Markets ex China and MSCI World Indexes.
As lower correlations would suggest, performance differences are beginning to emerge. Year to date through October 2023, the MSCI Emerging Markets ex China Index (2.7%) has outperformed the MSCI Emerging Markets Index (-1.8%).[1] An active-return attribution of the former over this period shows that within common factors, an underweight to China was the largest contributor to outperformance. This also indicates that risks related to China, such as its slowing economy and increasing regulatory curbs, had not spread to other EM equity markets. Some investors have considered carving out China from their EM allocations as a separate opportunity set to better manage diverging portfolio risks.[2]
Active performance attribution of the MSCI EM ex China Index
The analysis period is Dec. 30, 2022, to Oct. 31, 2023. Gross total returns in USD. Active performance of the MSCI Emerging Markets ex China Index is compared to the total performance of the MSCI Emerging Markets Index. Country performance reflects an underweight to China.
With the inclusion of China A shares in 2018, the market breadth of the MSCI Emerging Markets Index sharply expanded but without a proportionate increase in the index’s free-float market capitalization. In contrast, the MSCI Emerging Markets ex China Index had nearly two-thirds the amount of free float and roughly half the number of EM stocks as of Oct. 31, 2023.
MSCI EM and MSCI EM ex China Indexes compose different opportunity sets
The analysis period is from January 2000 through October 2023.
An analysis of the regions’ country, economic and sector exposures, as represented by the MSCI Emerging Markets, MSCI Emerging Markets ex China and MSCI China Indexes, revealed the following differences at the end of October:
Regional exposure. EM ex China had a 60% weight almost evenly distributed among Taiwan, India and South Korea, whereas EM was more highly concentrated, having a 30% weight in China.[3]
Economic exposure to China. EM ex China had about 8% exposure to China compared to exposures of roughly 32% and 88% in EM and China, respectively.
Sector and industry exposures. EM ex China had greater than 25% exposure to the information-technology sector[4] compared to roughly 6% and 20% in China and EM, respectively. China had exposure of more than 30% to the consumer-discretionary sector[5] versus nearly 7% and 14% in EM ex China and EM, respectively, and greater exposure to real estate than the other two regions.
Country, economic and sector exposures of the MSCI EM, MSCI EM ex China and MSCI China Indexes
Data as of Oct. 31, 2023. Sectors are the Global Industry Classification Standard (GICS®) sectors. GICS is the global industry classification standard jointly developed by MSCI and S&P Global Market Intelligence.
Managing emerging markets exposure
Notional open-interest trades in futures linked to EM, EM ex China, associated regions and single countries have shown consistent traction over the last five years. Delta-one derivative instruments, such as futures and swaps, could potentially be used to adjust a portfolio’s exposures in lieu of engaging in cash securities transactions. For example, suppose a long-horizon investor would like to reduce exposure to China without making changes to their EM equity portfolio. One option could be a tactical overlay in which they take long and short positions on futures linked to the MSCI Emerging Markets and MSCI China A 50 Indexes, respectively.
Other options for managing portfolio risks associated with regional EM exposures include:
EM ex China futures. Futures linked to the MSCI Emerging Markets ex China and China A 50 Indexes could be used to manage separate allocations to EM ex China and China. Separate allocations could result in a mild increase in decision-making complexity.
Regional futures. Futures linked to the MSCI Emerging Markets Asia, MSCI Emerging Markets EMEA and MSCI Emerging Markets Latin America Indexes in combination with futures linked to the MSCI China A 50 Index could be used to manage EM regional exposures.
Single-country futures. Futures linked to the MSCI country indexes, although possibly increasing the complexity of managing EM exposures, are another option. This approach could also be used to tactically adjust specific country exposures.
Steady trading level in futures linked to EM indexes
The analysis period is from January 2019 through October 2023.
Since the MSCI Emerging Markets Index was launched in December 1987, EM allocations have provided opportunities for return enhancement and risk diversification in global equity portfolios. The index’s large weight in China coincident with its falling return correlations with regional markets may suggest that China equities could be an opportunity set distinct from EM.
