Most investors are only vaguely aware of the scope of their investments outside of the U.S. International equity funds generally invest across a wide range of more than 50 developed, emerging and frontier markets. While the allocation between countries is generally assumed to be highly diversified, in fact a few larger markets dominate portfolios, and some of these allocations will increase based on relatively technical factors driving index weightings. These index weightings matter more than ever, with more than half of all mutual fund flows going to index-tracking funds, and more than one-third of all institutional assets being index-based.
Given how Chinese-U.S. relations are dominating the headlines, it is important that investors be fully informed about the largest shift in the risk profile of emerging market benchmarks since these indexes were first launched more than 30 years ago. These weight shifts now underway mean that more than 30% of most emerging market equity funds are already allocated to Chinese stocks, with the percentage growing further—to more than one-third—later this year, and likely rising toward 40% in the coming few years.
At the end of May, the flagship MSCI Emerging Market Index significantly altered its country weights by adding the first tranche of locally listed Chinese A-Shares to China’s already large overall weight in the benchmark—an overall index allocation to A-Shares that will grow from 1.1% to 3.3% by end-November 2019, on its way towards a projected 18% when fully included. Combined with the existing Hong Kong and U.S. listed Chinese stocks already in these benchmarks, China’s total weight in the index has already risen to more than 31%, will increase beyond 34% by year-end, and go substantially higher in the coming years.
Similarly, in late June FTSE Russell—the benchmark for many large institutional investors (such as CalPERS)—also began adding Chinese A-Shares to their flagship FTSE Emerging Markets Index, with similar ramifications. And most emerging market and international equity index funds from Vanguard, the most popular manager of funds for American individual investors, have already added the majority of the increased China exposure to their FTSE Russell-benchmarked funds over the past few years, so that their Emerging Markets Index fund has more than 33% of its $89 billion of assets invested in Chinese companies.
Finally, the third most popular global index family, calculated by S&P Dow Jones, will be adding Chinese A-Shares to their Emerging Market index in September, bringing China up to a weight of more than 35% in this benchmark which has its roots in the original IFC Investable Emerging Market Index family developed at the World Bank in the early 1990s.
With the higher allocation to China, the weight of the top five emerging markets now encompasses more than two-thirds of the index, creating what is known as concentration risk in these benchmarks and the funds that track them. And this risk will keep growing; it is quite possible that by 2022, Chinese equities with full A-Share inclusion will be close to a 40% total China weight, bringing the concentration of the top five countries in FTSE’s EM indexes to more than 80%, a level not seen since the early days of emerging market indexing when there were far fewer markets included in the index. (See Figure 1, below)
Figure 1: Top-Five Countries Dominate The FTSE EM Index
These changes constitute a dramatic concentration of global benchmark weights in a single country. In fact, by the end of this year alone, the Top 10 Emerging Markets will account for close to 90% of the MSCI Emerging Markets Index, effectively rendering many of the smaller 15 countries in the benchmark almost irrelevant.
Chinese stocks account for a similarly large percentage of index funds and ETFs tracking the MSCI Emerging Market index, including those from BlackRock/iShares, Fidelity, State Street/SPDR and Northern Trust).