If all goes according to plan, this month MSCI will pull the trigger on the first of a three-step process to further increase China’s weight in its emerging markets index.
The plan, announced in February, raises China A-shares’ inclusion factor in the index from 5% to 10% in May, to 15% in August, and finally to 20% in November.
By the end of 2019, China will account for nearly a third of the MSCI Emerging Markets Index, but that may not be where it ends. According to a consultation paper published by MSCI, a hypothetical full-inclusion scenario could see China’s weight increase to over 40% of the index in the future. Though it’s not exactly clear when the hypothetical would play out, an allocation that large would severely dwarf the next largest country, South Korea, which would account for less than 13% of the index. In fact, a weight that large would put China on equal footing with the next five countries combined, which begs the question we asked earlier: How distinct will the index actually be from what’s happening in China?
To try to answer that, let’s revisit the index’s prior 10 years of performance with the assumption that China’s weight had increased to 40% at the beginning of that period. We can then compare its results with those of the MSCI China Index to see how similarly they would have behaved. In creating this hypothetical index, we set China’s weight to 40% on December 31, 2008, and let its weight drift thereafter.
Sources: MSCI, Bloomberg, Parametric. For illustrative purposes. Not a recommendation to buy or sell any security. It is not possible to invest directly in an index.
The chart shows how China-like the hypothetical emerging markets index would have looked on a calendar-year basis, with very minimal deviation seen overall from what China alone was doing. In fact, the annualized returns over this 10-year period were 8.5% for the hypothetical index versus 8.3% for MSCI China, with both exhibiting very similar levels of annual volatility—28.8% for the hypothetical emerging markets index and 27.8% for the MSCI China Index.
But the similarity of returns isn’t limited to annual time periods—monthly returns yield a similar picture over this 10-year window. The graph below presents a scatterplot of monthly returns for the China and hypothetical emerging markets indexes. As we can see, the monthly returns for the two indexes moved together almost all the time. What’s more, if we dig into the numbers a bit further, we discover that 85% of the variation in monthly returns in the hypothetical emerging markets index is explained by China.
Sources: MSCI, Bloomberg, Parametric, 12/31/2018. For illustrative purposes. Not a recommendation to buy or sell any security. It is not possible to invest directly in an index.
In fact, it’s hard to imagine a scenario in which these two wouldn’t track each other—the remaining 23 (soon to be 25) countries in the index would need to consistently move in concert to crowd out China’s impact. Given that emerging market countries tend to be isolated from the global investor base and contain companies focused more heavily on their respective domestic market, this seems highly unlikely. Empirical evidence adds some credence to this viewpoint, since the average pairwise correlation of the countries in the MSCI Emerging Markets Index, excluding China, has been a meager 0.39 over the past five years. Such a low figure reinforces the notion that broad diversification should be sought out in this asset class instead of shunned as it is in the MSCI Emerging Markets Index.
The bottom line
Concentration risk is a familiar foe in the emerging markets asset class, where passive solutions have increasingly exposed investors to outsize exposures to the largest countries by market capitalization. MSCI’s announcement that China’s mainland market will see more inclusion in its emerging markets index by the end of 2019 reinforces that fact. And while that alone is cause for concern, more troubling is how China’s weight in the index is probably not done growing. Nothing against the Chinese market, but I’d prefer my emerging markets exposure be more than just a bet on China.