Insights, The Bridge
Jason Hsu, PhDScroll down
Some of you have noticed my recent hiatus from writing for The Bridge. My absence is primarily due to working on-the-ground in China and Taiwan.
It’s a fascinating time to live and travel in Greater China. While many are reading about greater China in the news, I’ve been experiencing that news first-hand at Rayliant’s offices in Shanghai, Hangzhou, Hong Kong and Taipei. I remain convinced it’s impossible to be an effective China manager without deep understanding and connection to the region.
Of course, whenever I return home to the US, I’m surprised by how little attention some asset owners give China. In fact, many say they “don’t invest in China” at all—despite having tens or even hundreds of millions invested in an emerging markets portfolio. These investors would be well-advised to understand the extent to which their EM portfolio is, in fact, invested in China. This is precisely why Rayliant manages both a quantamental China ETF and a quantamental Emerging Markets ETF.
My partner and colleague Matt Bowers often has a similar experience, and he recently wrote a short piece on just this point. I thought Matt’s article would be of interest to my readers and I’m sharing it below with his permission. In the meantime, I’ve started writing again – so look forward to more content on The Bridge in the coming weeks.
People often tell me they “don’t invest in China.” They are usually mistaken.
But how can this be? How can people not know they are China investors?
It’s not that complicated. Most diversified investors allocate part of their equities to so-called “emerging markets.” And more than half of these allocations are usually comprised of China (~35%) and Taiwan (~15%). People think their EM portfolio is broadly diversified by country. But most of their EM exposure and its performance comes from just these two allocations: China and Taiwan.
People believe they are “EM” investors. But mostly? They are China investors.
Why do I say “so-called” emerging markets?
Because what qualifies as an emerging market is more art than science. Most countries become “emerging markets” simply because there’s consensus in the investment community that it should be so.
But how does that consensus arise? Who decides the relevant dimensions and thresholds? Who decides when it changes? How do you meaningfully compare Taiwan with Qatar? Or Thailand with Mexico? Or Brazil with India? While all these markets are considered “emerging,” there are major differences within each market that affect how one might invest.
Many managers would say these differences don’t really matter… and they may be right. The reason is that each emerging market is just one small part of a diversified EM portfolio. For example, Mexico is 2.2% of the MSCI Emerging Markets Index. Qatar is 1.2%. Brazil is 5.29%. Broad exposure to a diverse array of these emerging markets means deep specialization in any one market is not cost-effective for most investors.
This is why, for example, most firms don’t tout their “Philippines” expertise when marketing broad-based EM strategies. It’s why they don’t have offices or a team of analysts on-the-ground in Manila. Because localization is expensive, managers must charge more to localize their strategies. And for most diversified EM portfolios, the cost of developing local expertise in any single market is not offset by the potential outperformance.
But China is 32.09% of MSCI (and may even be underweight). And Taiwan, its neighbor, is 14.60%.
Collectively, these two allocations account for approximately half of most EM portfolios. Given the massive size of the China and Taiwan positions in most EM portfolios, these two markets can make or break an entire portfolio’s performance. Investors should realize when investing in an “EM” portfolio that they are exposed primarily to China and Taiwan.
Here is the simple truth: most investors already have lots and lots of money invested in China and Taiwan. These regions are such sizable percentages of an EM portfolio, they might be better managed by people who specialize in these regions, whether as part of their broader EM portfolio or as separate allocations.
Let’s now focus solely on China.
I wrote earlier that what constitutes an “emerging market” is not a science. That doesn’t mean people don’t rigorously think about this question. But at best, it’s a multi-dimensional analysis that accounts for things like institutional stability, per-capita income, regulatory rigor, etc. And frankly, this question is more relevant to a debate about benchmarking than asset allocation.
China just doesn’t fit well as an “emerging market.” It’s too big, too dynamic, too unique to be lumped in with the general category of EM.
But here’s a (perhaps obvious) corollary: China is also not a developed market. China is too uncertain, too growth-oriented, too unique to be considered part of a conservative DM portfolio.
At this point in time, China’s risk profile is unique. Its return profile is unique. Its government and economy are unique. It has unique share classes and stock markets. It is subject to unique geo-political risks. It has low correlations with other global markets. But most importantly… it is HUGE.
So, what’s an investor to do?
One option is to carve out your China allocation. There are China specialists like Rayliant who offer dedicated China exposure. And advisers like The Colony Group have taken exactly this approach with their $19-billion portfolio, for reasons explained by Jason Blackwell last month. Other managers have been offering EM ex China strategies for years, allowing asset owners to allocate more tactically between China and the rest of EM.
But many of us aren’t interested in single country investing outside the US. Perhaps you’re worried about tracking error, or maybe you just want to limit portfolio complexity. If that’s the case, then your solution is much simpler: just find a China and Taiwan expert to manage your EM portfolio. Super easy.
You might wonder if it really makes a difference. We think it does. We encourage you to research the performance of EM strategies managed by China specialists, including Rayliant’s $RAYE, versus those who lack on-the-ground China experience.
Of course, past performance is never a promise of future returns. But performance alone isn’t the point. The more interesting question is why are they performing well or poorly? We think you’ll find that behind most high-performing EM portfolios, you’ll find outperformance within its China sleeve.
Regardless of whether you consider yourself a “China investor,” your EM portfolio is being shaped by China. This is why you probably want a China expert managing it. Doing otherwise risks material underperformance on a risk-adjusted basis over time.
We’ve all read about the “rise of China.” Most people read this through a geo-political lens. I understand this approach. I often imagine late 19th-century Brits reading about the “rise of America” in the same way or, more recently, how US workers experienced the “rise of Japan” in the 80s. For some people, a geo-political lens is the only important one, and I respect that. But it certainly isn’t the only available lens. As investors and global citizens, we can consider different perspectives over longer horizons.
As investors, China’s increasing economic prominence should make us question the traditional approach to investing in the region. At what point do China’s idiosyncrasies—its size, risks, returns, politics, share categories, state-ownership, etc.—warrant special consideration in an EM portfolio? I would argue that point has well arrived.
Major institutions have already recognized China’s transformation into a unique investment category. The great news is that, in this era of investment democratization, retail investors can join them.
At a minimum, investors should consider allocating to an EM strategy that is managed by a firm with China expertise. And for those ready to take a bigger leap, I would argue it makes sense to carve China out of an EM portfolio to make a dedicated allocation. But either way, China is just too big to ignore.
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