The Opportunity Cost of Relying on Emerging Market Benchmarks

When China joined the World Trade Organization in 2001, it only accounted for about 6.5 percent of the MSCI Emerging Markets Index. Twenty years later, the country’s weight in the index has risen to 34 percent.

Yet even that five-fold increase in the popular emerging market index does not fairly represent China’s role in the world economy, according to a new report by Acadian Asset Management. The firm estimated that Chinese stocks available to foreign investors account for 53 percent of emerging market capitalization, with Chinese companies delivering 48 percent of developing market revenues. The world’s second-largest economy, China also contributes to almost a quarter of the world’s GDP, with its share falling only 4 percentage points below that of the United States, according to the report.

“Allocators’ views are sometimes informed by popular benchmarks that are typically large-cap or mid-cap centric,” said Ram Thirukkonda, senior vice president at Acadian. “[But that’s only] part of the investible universe.”

One thing that China-focused indices have failed to capture is the $4.5 trillion onshore market, said Thirukkonda, who co-authored the paper with Acadian’s Seth Weingram. But it’s exactly the A-Shares market that can provide investors with the level of diversification they are looking for from emerging markets, he argued. For the past 30 years, the correlation between the MSCI EM Index and the 15 major developed market equity indices has more than doubled, demonstrating what Acadian called “the increased integration of emerging and developed markets.” But only 41 percent of China’s onshore market is explained by global risk factors, compared to 74 percent of China’s offshore market and 87 percent of the emerging market as a whole, according to the Acadian report.

The low correlation arises from several distinct features of the A-Shares market, the report said. For one, 80 percent of trading in A-Shares is driven by retail investors, compared to 20 percent of market activity in the United States. Second, the companies listed onshore are “more locally oriented” and “skew smaller-cap,” according to Acadian. While the offshore market is dominated by leading mega-cap tech stocks like Tencent and Alibaba, the onshore market offers more diverse exposure to sectors like healthcare and consumer staples. “The antidote... is to look explicitly for locally-oriented stocks,” Thirukkonda said. The A-Shares market, he added, could provide that distinct “local flavor” to portfolio managers.

But that doesn’t imply all types of institutional investors should dip their toes into the Chinese onshore market, Thirukkonda said. He recommended that those with more permissive investment mandates allocate assets based on fundamentals of their choice instead of relying too much on an index. Those restricted by a certain investment quota — say, a certain amount of assets that needs to be put into the emerging markets — should “take a more comprehensive approach” to China, Thirukkonda said. That means assessing emerging markets in three parts, including the onshore China market, offshore China market, and the ex-China emerging markets, he said.

“不管你希望overweight China [due to] fundamental drivers, or you are looking to underweight China [due to concerns over] geopolitical risks, it makes sense to look at the onshore market because of its distinctiveness from offshore” markets, Thirukkonda said.