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Point of View · 11.09.23

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

An analysis of risk, return, geography and sectors.

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

Key Points

What it is

We analyze how removing China from indexes affects risk, return and composition of those indexes.

Why it matters

China's large weight among emerging markets investments has become a potential diversification risk. Investors are seeking ways to manage that risk.

Where it's going

We don't think investors need to passively accept the country's weighting, as they can adjust exposure to China while still aligning with portfolio objectives.

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 , 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 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.

% weight of china within em equities and global equities

Source: Northern Trust Asset Management, Morningstar. Data from June 30, 2007 through June 30, 2023. Current weight (as of June 30, 2023) is in parentheses in the legend. Weights use IMI indeces. Historical trends are not predictive of future results.

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 . 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.

5 year annualized return and risk %

Source: Northern Trust Asset Management, Bloomberg. Risk is standard deviation. EM = MSCI Emerging Markets Index. Data from June 30, 2018 through June 30, 2023. See disclosures at the end of the report for indexes used. Past performance is not indicative or a guarantee of future results. Index performance returns do not reflect any management fees, transaction costs or expenses. It is not possible to invest directly in any index. Indexes are the property of their respective owners, all rights reserved.

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.

tracking error to broad indexes %

Source: Northern Trust Asset Management, Morningstar. Historical trends are not predictive of future results. See disclosure at the end of the report for indexes used. Data is as of June 30, 2023. Since inception data is from December 31, 1998 to June 30, 2023. The broad indexes are the MSCI Emerging Markets Index for the MSCI Emerging Markets ex-China Index and the MSCI ACWI IMI Index for the MSCI ACWI ex-China IMI Index. Tracking error measures the standard deviation of the differences between the investment performance of the strategy or fund and that of the Index. There is no guarantee that tracking error targets can be achieved; actual or experienced tracking error can deviate significantly. For illustrative purposes only. Past performance is no guarantee of future results. Index performance returns do not reflect any management fees, transaction costs or expenses. It is not possible to invest directly in any index.

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 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.

drawdowns over time through global financial crisis and covid-19 pandemic

Source: Northern Trust Asset Management, Morningstar. Drawdown is the decline from a recent peak using monthly returns. Global Financial Crisis data is monthly from September 30, 2007 through February 28, 2009. COVID-19 period data is daily from December 31, 2019 to March 31, 2020, representing the onset of the pandemic. Bottom Chart data from January 1999 to June 2023. Historical trends are not predictive of future results. EM equities = MSCI Emerging Markets Index. EM ex-China = MSCI Emerging Markets ex-China Index. China equities = MSCI China Index. Historical trends are not predictive of future results.

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.

super region weights and top coutnries by weights

Source: Northern Trust Asset Management, Bloomberg. Weights as of June 30, 2023 using IMI indeces. It is not possible to invest directly in any index. Indexes are the property of their respective owners, all rights reserved.

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 , with an overweight to technology companies offset by underweights to communication services and consumer discretionary companies. It has slightly less exposure to 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.

relative sector weights (em index ex-china minus em index %)

Source: Northern Trust Asset Management, Morningstar. Sector weights as of June 30, 2023. It is not possible to invest directly in any index. Indexes are the property of their respective owners, all rights reserved. EM index = MSCI Emerging Markets Index. EM Index ex-China = MSCI Emerging Markets ex-China Index.

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.

active risk for increasing allocations to china %

Source: Northern Trust Asset Management, Barra. Data as of June 30, 2023. Historical trends are not predicative of future results. China = MSCI China Index. EM ex-China = MSCI ex-China Emerging Markets 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.

Main Point

How China Impacts Your Portfolio

Removing Chinese equities from a global index impacts results enough to require a consideration by investors. For emerging markets investors, removing China creates potentially significant changes in returns, tracking error and risk. However, we don't think investors need to take an all-or-nothing approach, as they can adjust their exposure to China while still aligning with their portfolio objectives.

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