Should your emerging market ETF strip out China?

Even if an investor is bullish on China, there’s still good reason to choose an emerging market ETF that excludes the country. 

The past few months have left investors with significant exposure to Chinese equities licking their wounds. Owing to a broad regulatory crackdown, Chinese shares have seen significant price declines. Over the past three months, the MSCI China Index has lost over 9%, in sterling terms. Similarly, the FTSE China 50 Index has lost just over 7%, while the Hang Seng Composite Index has lost 7.6%.

Some view the China sell-off as a temporary setback and a potential buying opportunity. However, other investors are now questioning whether or not China has become “uninvestable”. According to this view, something has, or is, changing in China, with authorities much less concerned about the fortunes of private enterprises and shareholders.

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As a result, there has been renewed interest in emerging market funds that strip out Chinese exposure. Over the past few years, Chinese equities have come to represent an increasing segment of major emerging market indices. The MSCI Emerging Market Index, for example, had a weighting towards China of over 40% last year, before the tech crackdown and sell-off started. Similarly, at points in 2020, China came to represent almost 50% of the FTSE Emerging Index.

Since then, China’s weighting in both indices has fallen. However, the country remains well-represented. The MSCI index now has a China weighting of almost 34% and FTSE Emerging 38%. As a result, investors using either the iShares MSCI Emerging Market ETF or Vanguard Emerging Market ETF have had, and continue to have, significant exposure to China.

For investors hoping to reduce their China exposure, Lyxor MSCI Emerging Market Ex China ETF Acc (LSE:EMXC) is an obvious option. This exchange-traded fund (ETF), as the name suggests, tracks the MSCI Emerging Markets ex-China Index for an ongoing charge of 0.29%.

How does the index change without China?

The obvious difference gained by using this index is the absence of Chinese equities. This has several effects on the composition of the index and therefore the portfolio of an ETF tracking it. First, it has significantly fewer companies. The MSCI Emerging Market Index has just over 1400 companies. In comparison, the ex-China version has 677. That leaves plenty of companies in the universe, albeit significantly smaller than before, giving an indication of the number of Chinese firms.

However, removing China does result in a lot more single company concentration among the very biggest holdings. Taiwan Semiconductor, for instance, accounts for 6.7% of the broad emerging market index. Removing Chinese firms increases its weighting to over 10% in the MSCI Emerging Markets ex-China Index, which is a very high concentration. Meanwhile, Samsung goes from 3.9% in the broad emerging market index 5.9% in the ex-China version.

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The total concentration of top 10 companies in the index increases, albeit only slightly. The 10 biggest companies in the broad market index account for 24.5% of the index. Screening out China brings that to 25.4%.

There is also an increase in geographical concentration. Screening out Chinese stocks sees Taiwan’s weighting go from 14.8% to 22.4%. Similarly, South Korea goes from 13% to almost 20%. However, while screening out China ups the concentration of these two regions, their weightings are individually still smaller than China’s in the broad emerging market index. Arguably, removing China adds to somewhat to geographical diversification. With China in the index, the “other” category, which is the countries that are not the five largest weightings, sits at 21.6%. Removing China increases the weighting of this “other” category to 27.7%.

The other reason to remove China

Time will tell where Chinese equities go from here. Many investors, as noted, are still very bullish on the long-term prospects of the world’s, soon to be, largest economy. However, even if an investor is optimistic about the prospects for Chinese shares, there’s still a good reason to opt for an ETF that screens out China.

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China is now a huge and varied market. There are multiple ways to get exposure to country, be it through specialist ETFs or active managed funds. Investors now have access to ETFs that track the healthcare sector of China such as KraneShares MSCI All Chn Hlth Cr ETF USD (LSE:KURE). Or they have access to closed-end trusts such as Fidelity China Special Situations (LSE:FCSS), a member of interactive investor’s Super 60 list of rated funds, which has a large chunk of its portfolio in unlisted companies in China.

For the truly bullish on China, arguably having it as simply a big weighting in a broad-based emerging market index is not enough.