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Kicking the Elephant Out of the Room: The Case for EM ex-China

Jason Hsu, PhD

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This following article was first published to
Jason Hsu’s LinkedIn newsletter, The Bridge.
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For nearly a decade, I’ve encouraged emerging markets (“EM”) investors to manage their China allocation separately from the rest of EM. Unfortunately, this hasn’t always been an easy sell.


But it seems like investors are coming around. Of the 15 active EM ex-China funds currently available to US retail investors, 14 launched within the past three years.1 And when you include passive funds, EM ex-China is now among the fastest-growing asset categories in the world. In fact, Rayliant’s own active EM fund will be going ex-China in October.


Why are investors starting to split their EM portfolios into China and EM ex-China? Because it allows them to more carefully calibrate their EM exposure. In this article, I’ll explain why this approach makes sense.

Two Sides of the Same Coin

Many investors are familiar with Rayliant’s active China ETF. But at last week’s FutureProof Festival, I met several people who were surprised that Rayliant also manages an active EM ETF with a healthy track record.  Most said something like, “I thought you were a China specialist. I didn’t even know you managed EM!” Nothing could be further from the truth.

I have been designing EM strategies for almost two decades. In fact, the reason I launched RAYC is precisely because I saw first-hand the way China was impacting my clients’ EM portfolios. I felt they’d do better by breaking out their China exposure and giving it to a China specialist.


Unfortunately, my efforts have been hampered by the flipside of the coin. Because if an investor wants to manage China separately, they also need a separate EM allocation that doesn’t include China. And for many years, it was hard to find an active EM ETF to provide credible ex-China exposure.


But that’s changing. Even Rayliant’s own active ETF, RAYE, will be going ex-China at the end of October. This will allow investors to access broad EM exposure using RAYE while calibrating their China exposure using RAYC.

Putting Power Back in the Hands of Investors

Traditional EM—which is mostly passive2—has locked investors into markets and weights that, while not arbitrary, can often be controversial.3 EM is simply a more complex category than DM, with greater variation among constituent markets, governments, and regulatory regimes.4 By separating China and ex-China allocations, investors reclaim the power to make their own decisions about China.


So, what are some reasons an investor may want to calibrate the size and scope of their China and EM ex-China exposure? Let me discuss a few.


Reason 1: China’s Size Relative to EM


It’s hard to overstate the impact of China on an investor’s EM portfolio. As of August 2023, China was 29.8% of the MSCI Emerging Markets Index.5 Given its size, China can make or break an entire EM portfolio’s performance.


When a single region shapes so much of a portfolio, it makes sense to manage that region separately. This isn’t a novel idea. In fact, it’s the same rationale that leads many investors to manage their US allocation separately from the rest of DM.

Reason 2: Composition of China Exposure


As noted above, China is about 30% of the typical passive EM portfolio. But what is the composition of that China exposure?


This question is important. If you say you invest in Chinese stocks, it could mean many things. It could mean you invest in China ADRs6, which are Chinese companies listed on US exchanges. It could mean you invest in H-shares, which are Chinese companies listed in Hong Kong. Finally, it could mean you invest in A-shares—equities listed in Shanghai, Shenzhen, and now Beijing.


These differences really do matter. Because despite all being Chinese companies, these different exchanges list very different types of firms. ADRs and H-shares are disproportionately likely to be consumer tech firms. They also tend to be fewer but larger, whereas China A-shares are multitudinous but smaller cap. And China A-shares have historically been less efficiently priced, probably in part due to the higher level of retail trading on Chinese exchanges relative to US and Hong Kong exchanges.7


In short, “China exposure” can mean many, many different things. More importantly,  the size, scope and composition of your China exposure can have a profound impact on an investor’s overall EM exposure.8 By carving China out of a broader EM portfolio, investors have the ability to focus on the exact type of China exposure they want to achieve the investment objective of their broader EM allocation.


Reason 3: China Value Judgment


We live in complicated times. An increasing number of investors are choosing to invest based on their personal values, and some of them avoid China because they object to its government or policies.


EM ex-China gives these investors flexibility to access EM growth and diversification in a way that is consistent with their personal values, tailoring their China exposure based on those requirements. For example, they might purchase a thematic China ETF that focuses on a particular sector; or a China strategy with an ESG9 overlay that avoids certain industries or regions; or they might opt to stay out of China altogether.


Reason 4: Client Optics and Reputational Risk


Even if an adviser or institution doesn’t have an ESG or value-based judgment regarding China, it’s possible their clients do.10 At a minimum, some managers—like public institutions—are more exposed to reputational risk based on the size and nature of their China allocation. By carving China out of a broader EM allocation, they can better manage these risks in China while still obtaining broad EM exposure through an EM ex-China fund.


Reason 5: Investment Risk


I’ve written many articles about the idiosyncratic risks associated with investing in China. These range from different accounting standards to state-owned enterprises to unfamiliar listing practices. Investors who are aware of these risks increasingly prefer them to be managed by a China specialist. An on-the-ground presence in China helps specialist managers stay attuned to the country’s unique risks and their strategies should, as a result, be better equipped to achieve favorable risk-adjusted returns.


Reason 6: Complexity of China Data


Investing in China is complex. This is partly to do with the idiosyncratic risks and share types described above. But it’s also because China is a massive country with over 5,000 listed companies with voluminous (and sometimes conflicting) data sources … which are often written exclusively in Chinese.11 Given this complexity, investors may sensibly want to carve out their China exposure and give it to a manager that’s equipped to process Chinese data sources.


Reason 7: Calibrated Diversification


Many EM investors are looking to diversify and reduce the risk of their overall portfolio. For these investors, it’s important to understand the correlations between China, EM, US and developed markets (“DM”). One might even look at the correlation between types of China exposure—like A shares—and other parts of EM and DM.

As the chart above shows, the diversification benefit of EM can vary widely depending on both the size and type of the China allocation. By managing China separately from the rest of an EM allocation, investors can adjust the dials to optimize their diversification in service of their ultimate investment objective.

Closing Thoughts

For a long time, I’ve been saying that China is simply too big, too dynamic, and too unique to be lumped in with general EM. The good news is that, with the increasing availability of separate China and EM ex-China ETFs—including Rayliant’s own EM ETF—investors now have more power than ever to calibrate their exposure between China and EM. In my view, this is nothing but a good thing.


If you’re interested in hearing more on this topic (or asking me questions), please join me this Wednesday at 10:00am Pacific. I’ll be doing a webinar with my colleague, Professor Phillip Wool to discuss the case for EM ex-China in more detail.




1 Source: Rayliant Research, as of September 18, 2023

2 Source: Bloomberg data. The combined AUM of passive EM funds dwarfs that of active EM funds.

3 For example, with respect to China, there is a debate about how weights are allocated across different share types. See, e.g., “(Quietly) China A-Shares Account for 11% of Global Market Cap”, The Bridge, May 17, 2022. As another example, there is debate regarding whether some countries included in MSCI EM, like South Korea and Taiwan, should be considered “emerging markets” at all. See, e.g., “South Korea Has Had Enough of Being Called an Emerging Market”, The Economist, June 15, 2023.

4 Source: World Bank and International Monetary Fund (IMF) data.

5 Source: MSCI EM Index Data, as of 31 August 2023

6 The term American depositary receipt (ADR) refers to a negotiable certificate issued by a U.S. depositary bank representing a specified number of shares—usually one share—of a foreign company’s stock. The ADR trades on U.S. stock markets as any domestic shares would. Chinese ADRs are exposed to greater legal and regulatory risks do to the legal structure of the listed entities. Many investors are unaware of these risks. For more information, See Relative Regulatory Risk: A-Shares vs. H-Shares vs. ADRs – Rayliant Global Advisors.

7 Source: Rayliant Research, Wind data, Bloomberg data, MSCI data

8 Source: Rayliant Research showing broadly divergent performance among China ADRs, HRPs, and A-shares over time, resulting in varying investment outcomes depending on the type of China exposure held in a portfolio.

9 “ESG” stands for environmental, social, and governance. ESG investing refers to a set of standards for a company’s behavior used by socially conscious investors to screen potential investments.

10 See, e.g., “US Pension Funds, Universities Face Pressure Over China Investment”, Nikkei Asa, July 2, 2023

11 Source: Rayliant Research

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This material represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice and is intended for educational purposes only.




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