China in a bull shop - concentrated position

China in a Bull Shop? Single-Country Concentration’s Risks to Your Portfolio


Thanks to an increasing number of eligible securities, China’s weight in the MSCI Emerging Markets Index is close to 30%. What’s more, in June, when the index is set to begin including China A-shares—shares of Chinese companies, previously off limits to foreign investors, that are available for purchase by select foreign institutions—this figure could begin creeping upward, easily growing to 40% in the next several years.

While this objectively reflects the growing size of China’s equity markets relative to other emerging-market countries, it also introduces a number of concerns about holding such a concentrated country position in an emerging-markets portfolio. For investors used to following market-capitalization-weighted passive solutions, the situation may work against many of your investment goals in three major ways.

It doesn’t help you achieve your strategic asset-allocation goals

Most investors include emerging markets in their asset allocation to diversify against their developed-equity exposures, to gain access to the elevated growth rates these immature economies may experience, or both. However, the current makeup of the index short-circuits this motivation. Its approximately 55% exposure to China, Korea, and Taiwan means a majority of the index is in countries that are the most integrated into the global economy and hence offer far fewer diversification benefits than the more inwardly focused economies of smaller emerging markets. In addition, these top three countries are economically mature, having already gone through their hypergrowth period—as a result, they don’t appear to satisfy the second strategic goal terribly well either.

It doesn’t help you maximize your probability of success

In discussions with investors, we rarely hear much conviction behind the inordinate weight the index gives to China. However, the downsides are very apparent—such a degree of concentration means that for the index to succeed on an absolute basis, it’s increasingly essential for China to succeed. If China falls, it’s nearly impossible for the index to deliver satisfying absolute returns.

In contrast, a more diversified exposure can still deliver positive absolute returns even if China declines, since it’s less reliant on any single country’s return. Based on a statistical analysis of historical returns, we argue that all emerging markets essentially have the same expected returns. Because of this, as a portfolio moves closer to equal country weights, a diversified portfolio will likely outperform a concentrated one.

Put another way, a diversified portfolio isn’t as susceptible to the “feast or famine” scenario a concentrated portfolio risks facing. As a result, we believe capping exposure to China (and to any other country that may exhibit a large weight in the index) is in the best interest of a long-term holder of the emerging-markets asset class.

Concentration risk in emerging markets is scary

Given the news regarding property bubbles, growing debt, and government interference in corporate governance, China demonstrates any number of risks that could lead to a dramatic drop in equity values. This isn’t to single out China—consider recent events in Russia, Turkey, and South Africa. However, most of those countries don’t have a 30% weight in the index. Given the unpredictable nature of political, economic, and currency risks for any single country in isolation, we believe any material country concentration exposes the investor to undue downside risks, especially when these risks are easily diffused through country diversification. 

The bottom line

While we acknowledge that index solutions are increasingly viewed as being “risk free,” we argue that the increasingly concentrated positions in many emerging-markets indexes make them unsuitable as investment portfolios. Given this, we believe most investors should revisit their convictions regarding China’s growth story and consider whether a more diversified solution better suits their goals with regard to emerging-markets exposure.

> For more analysis on China’s weight in the MSCI Emerging Markets Index, download our whitepaper.


Potential Parametric solution

Our Emerging Markets Strategy is designed to provide all-cap exposure to countries with the potential to outperform the index, with less volatility. Our investment process is based on mathematical principles of diversification, compounded growth, and volatility capture.

Tim Atwill

Tim Atwill, PhD, CFA, Head of Investment Strategy (emeritus)

Tim led the Investment Strategy Team at Parametric, which is responsible for all aspects of Parametric’s investment strategies, until his retirement in 2019. He also held investment responsibilities for Parametric’s Emerging Markets and International Equity strategies as well as shared responsibility for the firm’s Commodities Strategy.

The views expressed in these posts are those of the authors and are current only through the date stated. These views are subject to change at any time based upon market or other conditions, and Parametric and its affiliates disclaim any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for Parametric are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Parametric strategy. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness. Past performance is no guarantee of future results. All investments are subject to the risk of loss.