With a backdrop of volatility, conflicting factors and potential opportunities, it was interesting to see how the allocation to China has varied over time among institutional asset managers who run global emerging markets or Asian ex Japan portfolios. We examined peer groups of 500 products in global emerging markets and 300 in Asia ex Japan:

The group was divided into percentiles according to their allocation to China, with the 5^th percentile being those managers who were the most underweight, 25^th percentile less so, with the 75^th and 95^th percentiles being those who had the smallest underweight or indeed an overweight position.

Examining the chart highlights two features:

·      Most managers were underweight to China compared to the index. Only those at the 75^th percentile matched the benchmark, and not until the 95^th percentile is there evidence of an overweight allocation.

·      The extent of the underweight or overweight was fairly constant through time. Managers appear to have maintained an almost “strategic” position to China and have not changed from year to year, regardless of news or changing opportunities.  

These observations were a surprise, given the significant turn of events in China, whether it is improved market access, significant growth and reversal of the technology stocks, trade wars, the pandemic, geopolitics and economic volatility. We had expected a more active approach to managing the allocation to China – adding when opportunities were better and reducing when not. Instead, changes by individual managers were either not sufficient to move the averages or were offset by each other. 

The results are slightly different among the Asian equity managers. They seemed to have reduced their underweighting to China gradually. Allocations relative to benchmark were also more sensitive to shorter-term outlooks. The underweighting to China is far larger for Asian managers than for the emerging market managers. China is almost half of the MSCI Asia ex Japan Index and most managers prefer not to have such a high allocation to any single emerging market.

A look at manager subgroups in more detail.

The typical emerging market manager maintained around 4% – 5% underweight to China over the last five years.

A challenge for emerging market managers is that they often don’t have sufficient resources to sift through the thousands of companies in China, spend hours researching these companies, especially in the absence (or certainly lack) of independent research from brokers or banks to ease their workload. A number of global managers have told us that they can go through three to four companies in India or Brazil in the same time it would take them to research a single mid-cap name in China.

That said, the median global emerging market manager has also accepted the importance of Chinese A shares. Emerging trends – such as the green economy, electric vehicles and semiconductors – are more likely to be found in the A-share market.

As a result, most emerging market managers based in developed markets are investing to improve their coverage of Chinese companies. This includes recruitment of Mandarin speakers or opening research offices in Shanghai.

Even managers who are positive about China have not been significantly overweight over the last five years. Among Asian managers, only the 5^th percentile had half their portfolios in the country matching the MSCI Asia ex Japan Index. This may be because they found adequate investment opportunities elsewhere in emerging markets and managers operating in emerging markets typically emphasize country diversification.

It seems the strategic allocation to the country is almost a separate view, driven by a philosophical assessment of a state-driven country with undoubtedly higher government intervention as opposed to investment style or team size. We found the same to be true for the bears.

Among the emerging market managers, the lower quartile has maintained an underweight of around 10% – 15% throughout.

This group typically has a very high threshold before including companies listed in China. They would either cite poor governance or the ability of the state to interfere with the running of companies for their reluctance to invest. Even if they were reconsidering this view, it was agitated by Russia’s invasion of Ukraine.

We struggle to sympathise with this stance by an emerging market specialist. Governance is a challenge across all emerging markets – not just in China. These same managers often charge premium fees to justify the “more complicated work” that needs to be done to meander the opportunities and challenges in emerging countries.

Asian managers seem to have taken a different approach. Managers who historically had a smaller allocation to China were forced to change tack with the opening and significant growth of the A-share market and given that they are “Asian specialists” after all. The lower quartile’s exposure to China increased from approximately 10% of their portfolio to a peak of 30% last year. Even the 5^th percentile increased from no exposure to China to about 10%.

Many managers based in Hong Kong and Singapore were historically sceptical of China’s ability to grow its economy sustainably. However, given their proximity to China, they saw the emerging trends and poured significant resources into researching Chinese companies. Many of them launched dedicated China products and set up offices in Beijing or Shanghai if they hadn’t before.

We did this research expecting large variations in global emerging market managers’ allocations to China. We were surprised to find that institutional managers in this asset class have, in aggregate, been more strategic in nature and maintained their position, both positive and negative, regardless of the multiple events that have happened in the country over the last five years.

One thing is for sure. Geopolitics are here to stay and fund managers have to try to understand the consequences of world events whether it is increased nationalism, trade wars and unfortunately risk of wars. It is important for schemes to understand how equity fund managers, both bulls and bears, are assessing these risks when researching and investing in companies. The China optimists should be questioned on how they are talking account of the higher risks of investing in the country whereas the bears need to be asked the opportunity cost of not investing in the second largest stock market in the world and especially at such depressed valuations.