China’s weight among emerging markets equities has risen significantly since the Global Financial Crisis in 2008, peaking at about 40%. As a result, investors are looking for ways to manage risk of this outsized weight, or even remove Chinese equities , without significantly affecting performance. We analyze China’s impact on emerging markets and global indexes, and we propose how investors may seek to control China’s influence in their emerging markets equity allocation.

A Growing Influence

As shown in Exhibit 1, China’s weight was well under 10% of the MSCI Emerging Markets Index as recently as 2007. Afterwards, the nation’s clout and weighting in the index began to rise as its economy strengthened and its stock market rapidly added new listings. The weighting increase in the index continued until 2019, reaching a peak of about 40% of the MSCI Emerging Markets Index. It has declined somewhat since then, sitting at 27% as of June 30, 2023.

Even at a quarter of total market capitalization for emerging markets, China remains a relatively small piece of the global market, at 3% of the global MSCI ACWI IMI Index. To put that in perspective, Apple represented about 4% of ACWI IMI as of June 30. In other words, removing China from the global portfolio is somewhat akin to choosing not to hold the Silicon Valley tech giant. This may not seem significant, but for passive investors, this does introduce meaningful tracking error relative to the global opportunity set.

EXHIBIT 1: China's weight still relatively small in a global context

China has risen to represent 27% of the MSCI Emerging Markets Index, but it is only 3% of the MSCI ACWI IMI Index.

Index Performance With and Without China

With these index weightings in mind, we compared the performance of the emerging markets and global equity indexes “with China” and “without China”. We looked at since inception of the MSCI Emerging Markets Index and the more recent five-year period. We think the five-year period better represents China’s current impact on equity markets and the impact that investors may expect in the future.
 

As shown in Exhibit 2, here’s what we found:
 

• The MSCI Emerging Markets Index returned 1.3% annually the past five years with volatility, as measured by standard deviation, of 18.9%. Removing China would have led to a 3.4% higher annualized return with just a 1.2% higher risk.
  
  
• At the global level, the differences are less pronounced. The MSCI ACWI IMI Index returned 8.6% annually over the past five years with a risk level of 17.9%. Removing China increased the return by 0.6% and risk by 0.3%.
  
  
• Notably, the indexes without China outperformed, because of China’s underperformance during the period as the country’s economy struggles to recover from the pandemic.

EXHIBIT 2: WIthout China, index risk-return profiles change

While return and risk changed significantly with China in the emerging markets index, the impact was less notable in the broader global index.

Based on this simple analysis, removing China from the emerging markets index impacted results but made little difference on the global index. For a more sophisticated view, we examined China’s exclusion from a few other angles: tracking error, periods of stress, geographic profile and sector profile.
 

China’s Impact on Tracking Error

The question of tracking error can be front-of-mind for investors when it comes to managing risk from China equities. They may want to understand how much the index’s performance without China differs from the benchmark index that includes China. We can demonstrate this through historical tracking error, or the percentage that the ex-China index differs from the benchmark index over a given time period. Exhibit 3 shows the tracking error of the MSCI Emerging Markets ex-China Index against the broader MSCI Emerging Markets Index, again since 1999 and over the last five years.
 

The five-year data suggests that in any given year, an ex-China emerging markets investment is “likely” to outperform or underperform the MSCI Emerging Markets Index by as much as 8.2%. That is a significant number and comparable to a concentrated active equity manager. However, at the global equity portfolio level, removing China becomes much less noticeable, having produced a historical tracking error of 1.0%. This number, although smaller, is still significant for tracking error conscious investors whose investment policies may stipulate MSCI ACWI IMI as the performance benchmark.

EXHIBIT 3: Lower global influence on tracking error

While removing China from the MSCI Emerging Markets Index produced significant tracking error given its high weight, the impact on the Global ACWI IMI Index is much smaller since inception and over the last five years.

Stress Testing: Mixed Results

Often times, investors want to understand the impact of their decisions during times of market stress, because these are times when even seemingly minor decisions can have an outsized effect.

The top charts of Exhibit 4 highlight the performance of Chinese equities and emerging markets equities, both with and without China, during arguably the two most prolific stress periods of the recent past — the Global Financial Crisis and the COVID-19 pandemic. China modestly protected to the downside during the onset of the pandemic in the first quarter of 2020 but slightly exacerbated the drawdown during the Global Financial Crisis.

In the bottom chart of drawdowns since 1999, we find that China tended to be more susceptible to drawdowns than the full index. However, we expect that for a single country versus a more diversified group of countries found in the index. Notably, the differences in drawdown between emerging markets equities and emerging markets ex-China are fairly immaterial.

EXHIBIT 4: China shows mixed results during recent market shocks

China limited some downside at the onset of the pandemic in 2020, but it fared worse during the Global Financial Crisis from 2007 to 2009. During drawdowns since 1999 (bottom chart), the emerging markets indexes with and without China have performed similarly.

Regional Analysis: Asia-Pacific Remains Influential without China

Now let’s look at China’s effect on index composition through regional and country weights. We appreciate that removing Chinese companies doesn’t remove all Chinese revenues or input costs, thanks to non-Chinese multi-nationals throughout Asia.

The MSCI Emerging Markets Index contains an eye-catching 78% allocation to the Asia-Pacific region, as shown in Exhibit 5. Even when removing China and its 27% weight, Asia-Pacific still represents 70% of the remaining index due to the significant weights of other markets in the region including 22% for Taiwan, 22% for India and 17% for Korea. So even though investors can remove or manage direct exposure to China, Asia-Pacific’s presence remains strong with influence from the other key countries in the region around China.

EXHIBIT 5: Without CHina, Asia-Pacific still weighs heavily

Without China, Asia-Pacific countries still would represent 70% of the MSCI Emerging Markets Index.

Sector Analysis: A Cyclical Tilt in China

In Exhibit 6, we turn to the sector-level effects of removing China from the MSCI Emerging Markets Index, grouping sectors into three categories:

• Cyclicals: sectors most sensitive to changes in macroeconomic activity
  
  
• Secular Growers: growth-oriented sectors riding longer term demand trends
  
  
• Defensives: sectors showing stability during economic weakness
   

Emerging markets ex-China have more exposure to cyclicals such as financials, energy and materials and less though mixed exposure to secular growers, with an overweight to technology companies offset by underweights to communication services and consumer discretionary companies. It has slightly less exposure to defensives including real estate and health care underweights. While we aren’t analyzing the outlooks for these sectors here, we think investors should be mindful of how the change in sector makeup may impact portfolio risk and return.

EXHIBIT 6: Without CHina, exposure to cyclicals increases

Removing China makes the index more sensitive to cyclical sectors (financials, materials and energy) and less sensitive to secular growers, where decreases to the consumer discretionary (-6.5%) and communication services (-4.2%) sectors offset an increase to the information technology (+6.3) sector.

China Exposure: All or Nothing?

With the possibility that China’s significant weight in the MSCI Emerging Markets Index may grow meaningfully larger in the years to come, investors may want to maintain passive exposure but not necessarily at the weights dictated by the broader benchmark. To help control risk, one option for investors is to take a building block approach and create custom weights that suit their needs by investing in MSCI China and MSCI ex-China separately.

Exhibit 7 shows how an investor may choose to dial up or down exposure to China while still using passive indexes. The chart shows the expected active risk, versus the MSCI Emerging Markets Index, of portfolios comprised of varying allocations to the MSCI China Index and MSCI Emerging Markets ex-China Index. Active risk falls to zero at the portfolio comprising a 27% weight for the China index and 73% weight for the emerging markets ex-China index because that portfolio represents the MSCI Emerging Markets Index, which had a weighting of 27% to China as of June 30, 2023.

Fully excluding China results in an expected active risk of 6.48%, which may not be palatable for benchmark-aware investors. A more modest approach of adjusting the weight of China to, say, 20%, would result in an expected active risk of 2.09%, which may be more acceptable. As a practical matter, investors that take this type of approach to custom weighting China may want to consider aligning the decision with their target benchmark. In other words, choosing to avoid investing in China but leaving one’s target benchmark as MSCI Emerging Markets may create misalignment in the risk budgeting process.

EXHIBIT 7: Customizing Exposure to China through passive Indexes

Removing than removing China, investors can dial down their risk versus the benchmark index through varying portfolios of the MSCI China Index and the MSCI Emerging Markets ex-China Index. Similar to tracking error, active risk for each portfolio represents the amount of risk investors that versus the MSCI Emerging Markets Index, with a higher percentage indicating more risk of underperforming the index.

Key Considerations for China in the Portfolio

Based on our analysis, removing Chinese equities from a global index has enough of an impact to results that a thorough understanding is required. The tracking error of removing China from the portfolio is significant for emerging markets investors. And although the impact is less prevalent in a global context, for passive investors it is still not something that can be overlooked.
 

While some investors may want to remove China altogether, another approach investors can take is to adjust their exposure to China through combinations of passive indexes.
 

Ultimately, this is an implementation decision for each investor to make on their own, and the decision depends on risk tolerance and views on the outlook for China. But we think investors, particularly passive index investors, do not necessarily need to accept China’s weight in the index as a given, and there are options available for investors that wish to make adjustments.