The ‘Ex’ Has Issues
Key Takeaways
Due to China’s strict policies during the pandemic and the resulting poor market performance, many investors turned towards emerging market ex-China funds (ignoring the fact that China currently forms 25% of that market weight), increasing their concentration risk.
In addition, the S&P 500 has beaten E.M Funds 8 out of the 10 past years — making it easy to forget the benefits of diversification, or why investors should be looking at emerging markets at all.
However, we should remember that the decade prior (2000-09) investing in the S&P 500 would have yielded a total return of -9%, compared to a global approach of 36% or Emerging Markets which returned a stunning 162%.
A diversified approach ensures that we allocate to all available markets around the world. Investing should be flexible and systematic in a way that navigates the changing economies around the globe
“A bad year in China is a great year in any other country.”
— Ray Dalio
After a decade of insipid market performance, it’s no surprise investors are questioning why they should invest in emerging markets. Out of the Emerging Market component, China currently forms 25% of the market’s weight; however, at its peak, China was almost 43% of the Emerging Market index in 2020. You can see that it has fallen quite a fair bit in the past 4 years.
The large dispersion started to occur post-COVID, with China’s social distancing policies in stark contrast to the rest of the world, which had started to open up. This weighed on the economy and sentiment and impacted the stock market quite dramatically.
Given its imploding property market, challenging demographics, and slowing growth, investors started to shun China, preferring to invest in other emerging markets such as Taiwan and India. As a result, fund companies have launched a record 38 emerging market ex-China funds in 2023 and 2024. Data from EPFR shows the huge rise in assets flowing EM ex-China funds — over 2,300% for the past 3 years.
As we have warned many times in the past, we want to be wary of sentiment extremes. When everyone begins piling into a theme, any moment from then on could mark a major turning point. And that turning point came — out of the blue on 24 Sep 2024, the Chinese government unveiled its most aggressive stimulus since the pandemic; cutting interest rates, relaxing rules for homebuyers in major cities, and lowering banks reserve ratio in an effort to stimulate the economy. This has led to a sharp rally in Chinese stocks which has surprised many and has left investors who had little to no Chinese market allocation to scramble to buy in.
The chart above shows the performance of Chinese stocks, Emerging Market stocks, and Emerging Market stocks (excluding China) over the past 1 month. The opportunity cost of excluding China would have been painful for investors who had rotated out of the country.
Investing in Emerging Market vehicles which exclude China also comes with its own problems. When you take out the large chunk which constituted China, you need to replace it with something else resulting in a higher concentration risk. As a result, these funds would have had to allocate a lot more to Taiwan, India, and Brazil stock markets, all of which come with their own economic and political problems.
This would have led to an over-allocation to the two countries which had done well in terms of stock market performance over the past four years and can currently be considered overvalued.
Because of the skewed country allocation, the sector allocation is affected as well, with a large overweight in the technology sector — a sector which is arguably expensive at a price/earnings (P/E) ratio of 38.18 as of 3 Oct 2024.
Even without China’s underperformance, Emerging Market stocks have underperformed US stocks in 8 of the last 10 calendar years. In terms of country exposure, the Russian war and corresponding sanctions caused Russian stocks to plummet and were excluded from all major indices in the first quarter of 2022.
If you had just allocated to the S&P 500, you would have had a 175% outperformance versus emerging markets. These types of periods make us forget about why we should diversify, especially during such a long lasting trend such as this one.
However we should remember that the decade prior from 2000 to 2009 the script was flipped around; investing in the S&P 500 would have yielded a total return of -9% compared to a global approach of 36% or Emerging Markets which returned a stunning 162%.
It is hard to time and is very stressful to always be thinking about which country you should be allocating to and what corresponding weights are appropriate. A diversified approach solves these issues and ensures that we allocate to all available markets around the world. At the moment, developing countries make up around 12% of global equity markets. In the future, who knows — maybe emerging markets may form 30 or 40% of a portfolio.
A flexible and systematic approach can navigate the challenges of how and when we should allocate to certain countries. The diagram below shows a flexible market cap-indexed approach where allocations to the appropriate countries change with time and how markets move. Our core portfolios employ this systematic process to ensure that your allocations keep up with the times and do not get left behind in the dust.
As such, a core equity allocation would have held an approximate 3% in Chinese equities at the end of Sep 2024. This amount would have risen over the past week given the recent rally. Through this diversified approach, there is no need to chase markets when things suddenly change, as our dynamic allocations evolve along with the circumstances around the globe.
For more information on how a diversified approach can help you invest more consistently over time, come and have a chat with us.
