China is arguably the
world’s biggest economy. [1] It leads the world in
terms of manufacturing output, accounting for 20% of global production. [2] It is also the largest
market for a plethora of products, from smartphones [3] to cars. [4] One area of breakneck
growth has been Chinese e-commerce and technology firms. [5] Companies such as Tencent [6] or Alibaba [7] have gained multibillion dollar
valuations, while Chinese founders such as Jack Ma have become household names. [8]
With China responsible
for so much economic activity, it is no surprise that the country has come to
represent an ever greater share of the MSCI Emerging Market Index, now
representing over 30%. [9] Similarly, China accounts
for around 35% of the FTSE Emerging index. [10] Meanwhile, the Emerging
Markets Internet & Ecommerce Index (EMQQ) has roughly 60% in China. [11]
We believe many
investors are looking for exposure to a fund tracking one of these emerging
market indices, this creates a potential problem. While some investors may be
keen to have gain such a high weighting towards China from these indices, for
others this is less desirable.
There are several
potential reasons for this. Some investors may fear further regulatory
crackdowns on Chinese e-commerce. In 2021 several prominent Chinese tech
companies faced increased scrutiny from Chinese regulators. [12] Others may have a bearish
outlook on the Chinese economy. [13]
For many, however, it
is simply a matter of portfolio diversification. Many investors may already
have a high weighting towards China, with large Chinese companies being a
favourite among active managed funds in recent years. [14] At the same time, with
China’s economy and business landscape so varied and diverse, [15] many investors may wish
to gain their China exposure separately. This may entail going for a more
specialist, China focused fund.
Removing a country that
dominates one region from an index or investment universe is common practice.
Owing to the size of the UK market, many Europe funds remove UK holdings. [16] Likewise, the dominance
of Japanese companies has seen many investors focus on Asia-Pacific ex-Japan. [17]
Therefore, to avoid
doubling up on Chinese exposure, investors have been looking for funds that
remove Chinese stocks. [18] One option is to use a
fund that tracks the MSCI Emerging Market Ex-China index. As the name suggests,
it removes China from the emerging markets index. This leaves the investor with
around 24% in Taiwan,19% in South Korea, 19% in India and 6% in Brazil. [19]
However, one potential
downside to this approach is the particular type of company it leaves the
investor with heavy exposure to. Taking out China means that Taiwan
Semiconductor Manufacturing (also known as TSMC) accounts for around 10% of the
index. TSMC is one of the world’s largest companies, meaning investors may
already have a relatively high exposure. But beyond this, it is questionable
how much this can be considered a company providing exposure to emerging market
growth. That is because TSMC derives the majority of its revenues from North
America. [20]
While based in an emerging market (Taiwan), from a revenue perspective, it can
be argued that the company has more to do with developed markets.
Similarly, Samsung is
the second largest holding, account for over 5%. Samsung revenue has more
emerging market exposure, but a large chunk is still derived from North America
and Europe. [21]
This matters for
investors trying to tap into the emerging market growth story. When
it comes to emerging markets, arguably the rise of the consumer is the real
story. [22] As developing economies
become richer, citizens of these countries have more money for consumption. The
newly emerging middle class has rising disposable income and spends it on
better food, clothing, education, and entertainment. [23] The companies offering
these goods and services potentially stand to benefit. Indeed, McKinsey has
called it the “the biggest growth opportunity in the history of capitalism.” [24]
Much of this demand
will also come in the form of e-commerce. [25] However, rather than established
Chinese or US firms benefiting from this, increasingly local entrepreneurs are
doing so. As Brookings notes: “Homegrown entrepreneurs are uniquely positioned
to take advantage of the digital trade opportunity.” [26]
With this in mind, a
potentially preferable index for emerging market without China is the FMQQ Next
Frontier Internet & Ecommerce Index. This index is the same as the EMQQ Emerging
Markets Internet & Ecommerce Index but with China stripped out. It follows
the same rules for selecting companies and hence captures the same e-Commerce
growth, except that it excludes Chinese companies. [27] In our view, it gives
investors the flexibility to deal with their China allocation separately while also
gaining exposure to the boom of e-commerce in emerging and frontier markets.
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ETFs, your capital is at risk.