Overview

China's immense economic opportunity has led the country to outgrow its standing as merely a component of a broad emerging markets investment allocation.

• Market dynamics warrant carving out a separate China-only allocation for the customization needed to invest in such a large market.
• More limited industry exposure of individual emerging markets, compared to the broad industry diversification of China, means smaller countries benefit from being grouped together in a broad index to manage diversification and mitigate the risks of industry concentration.
• Investing in separate China-only and ex-China equity allocations may unlock the alpha potential of the emerging markets universe by providing flexibility and precision in both areas while avoiding the single-country dominance of a blended universe.

As a key driver of global growth, ranking either first (by Purchasing Power Parity) or second (by notional Gross Domestic Product), the importance of China as a leading player on the world's economic stage is beyond dispute. It's therefore likely that asset owners could benefit from some exposure to China in their overall portfolios. The challenge for equity investors is determining the best way to get that exposure. Traditionally, emerging markets indexes were the obvious choice; their small, but growing, allocations to China reflected the country's economic appeal while providing access to an extensive set of constituents in a broad index. However, as China's influence and weighting in emerging markets indexes grow, so do the risks of a single country dominating what's meant to be a broad and diversified allocation. Recognition of the excess return benefits of the other markets in this space leads us to believe that investing in separate China-only and ex-China equity allocations through diversified and risk-controlled portfolios can truly unlock the alpha potential of emerging markets.

At the close of 2022, China's weight in the MSCI Emerging Markets Index stood at about 30%, but could increase to almost 50% if all domestic listed A-Share securities are added. The potential for growth is even greater if MSCI increases the float adjustment. There's a school of thought that 30% exposure is actually too low given the pent-up domestic demand created as a result of COVID, which is about to be unleashed, combined with today's attractive valuations of Chinese equities. But the past year has been a case study for the risks inherent in investing in China: slowing economic growth, rising government intervention, heightened regulatory scrutiny, increasing geopolitical risk, likelihood of rising COVID infections and possible resultant restrictions, and a more aggressive regional stance are key reasons to underweight China allocations. It's important to note that, regardless of the relative strength of China-based stocks right now, the standard emerging markets index allocation is dominated by China, suggesting that investors would benefit from having distinct China-only and emerging markets ex-China allocations.

An emerging markets strategy that excludes China-based securities can provide attractive alpha opportunities versus its benchmark. Utilizing a model that generates alpha through both top-down, country-industry allocation and fundamental-driven, bottom-up stock selection presents additional diversification benefits when the focus on China is removed, conferring a clear advantage in global emerging markets investing. A top-down approach that considers the intersection of country and industry alpha can capitalize on broad regional opportunities. When paired with bottom-up stock selection insights that seek to systematically and effectively identify future stock outperformance based on fundamental metrics, investors are more likely to find alpha across all countries within the emerging markets universe. In fact, our research has shown no alpha degradation between including and excluding China from the emerging markets universe.