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MarketScape · 12.11.23

The Case for Separating China from Emerging Market Index Investments

China’s stock market has not only underperformed most other emerging markets over the past decade, it is now distinctly different from them. Investors may want to consider China separately.

  • Portfolio Construction
  • Index Equity
  • Equity Insights
  • Market & Investment Trends

Key Points

What it is

We explain why emerging market index investors may want to separate China from emerging markets.

Why it matters

China’s heavy weight in emerging markets means it can sway investment results significantly.

Where it's going

China’s equity market has become distinctly different from other emerging markets, potentially justifying separate treatment by index investors.

While China has chalked up an impressive 6.2% real economic growth rate annually over the past decade, its equities have underperformed most developed and emerging market benchmarks. We attribute the failure of China’s stocks to reflect its economic growth to two sources: declining productivity on capital invested and a high level of share issuance. As China’s equity market trends have diverged significantly from other emerging markets, we think investors, including those who invest in emerging markets indexes, should consider separating out China.


Over the last decade, while the Chinese economy has expanded rapidly, the correlation between economic growth and equity returns has been on a steady decline, leveling near zero for the last several years. However, the historical relationship between economic growth and equity returns for any country has been shaky, at best.  Far more important to equity returns is a country’s marginal product of capital, or the rate at which economies expands for a marginal investment in capital. China, already with one of the highest levels  of capital investment among emerging market countries, finds incremental capital less and less productive.  In the last decade, the marginal product of capital has declined 60% and is now in line with developed markets and far below other emerging markets. This decline corresponds very closely with the relative underperformance of Chinese equities. Notably, Moody’s last week downgraded the country’s credit outlook to negative.


Also important is the of Chinese equity returns through very high levels of share issuance.  While the total earnings of Chinese stocks have been relatively high, a large volume of share issuance has consistently driven earnings per share numbers and, hence, equity returns down. Over the last 10 years, average annual equity returns gross of share issuance have exceeded 15%, but increasing share counts have driven net returns to just 3.4%, a drain of a staggering 11.6 percentage points per year.  This represents the highest dilution of any emerging market country and far exceeds the 1% drain experienced among global stocks.


We feel the patterns of declining marginal product of capital and elevated share issuance won’t change anytime soon.  For these and other reasons, we have a underweight to emerging market equities, where China holds the heaviest weighting. China Moreover, we think index investors should consider China should from the emerging market equity indexes as these trends have made investing in China distinctly different from other investing in other emerging markets.

Main Point

Index Investors Could Approach China Differently

We think China’s underperformance and market trends over the past decade has caused index investors to more closely scrutinize including China in their portfolios. It may make sense to separate China from other emerging markets, given China’s distinct differences. We think China’s underperformance and market trends over the past decade has caused index investors to more closely scrutinize including China in their portfolios. It may make sense to separate China from other emerging markets, given China’s distinct differences.

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What Happens if Investors Remove China from Emerging Markets and Global Indexes

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Michael Hunstad, Ph.D.

Deputy Chief Investment Officer & Chief Investment Officer of Global Equities

Michael Hunstad is deputy chief investment officer and chief investment officer of global equities for Northern Trust Asset Management. Michael is a member of the Asset Management Executive Group and has oversight of all equity portfolio management, research and trading activities including quantitative, index and tax-advantaged strategies. Additionally, he assists with the development of investment vision, strategy portfolio construction and risk management framework for the firm’s broad investment platform.

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 Source of data: Northern Trust 2024 Capital Market Assumptions research


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