While we are not predicting a similar sharp drop in Chinese equities today, it is always a possibility, especially given the disruptive trade war underway between China and the U.S., and the rising geopolitical tension in the East Asia region. But even if the risk of such a correction may be low, having an index-tracking strategy with more than one-third of its weight in a single market can be considered imprudent.
Emerging market country (and sector) concentration is a natural outcome of capitalization-weighted index construction and should be assessed—and in BlueStar’s opinion, challenged. But regardless of the pure investment implications, American investors—who are embracing mission-driven/values aligned investment at a rapid pace—should also consider whether they are comfortable on a policy level with such a major allocation to China.
Mitigating Emerging Markets Concentration
Given the growing allocation to China in standard emerging market benchmarks, which drives high weights in both index and active funds, investors should "look under the hood" of their portfolios and consider ways to mitigate the concentration risk. BlueStar has designed several index-based solutions to mitigate the impact of idiosyncratic country and sector specific events, while considering other risks relevant to emerging market investors including operational risk, stage of development, volatility and correlation among countries and sectors. The BlueStar Emerging Markets Risk-Controlled Strategy Index is designed to deliver broad emerging market exposure while attenuating country and sector concentration, resulting also in a lower weight for Chinese equities.
Regardless of where you or your organization stand on the topic of trade negotiations, human rights policies and geopolitical tensions between the U.S. and China, it is imperative for investors look under the hood of their international equity portfolios to be aware of the extent of exposure to Chinese companies. And regardless of one’s investment philosophy, approach and choice of vehicles, investors must be aware of the current concentration risks in emerging market benchmarks, and how they are growing even larger starting this year…Caveat Emptor.
Steven Schoenfeld is the founder and chief investment officer of BlueStar Indexes.