Why an Emerging Market ex China strategy offers a new opportunity set

China’s increasing dominance within the emerging markets investable universe has numerous implications for strategic asset allocation and for allocators seeking to diversify sources of alpha across return-seeking assets. Despite heightened geopolitical risks and volatility, China plays a critical role within global portfolios and within EM equity allocations. The decision of whether asset owners want to invest in China and how to go about doing so is a complex and subjective topic but deserving of serious consideration.

As a specialist manager in Asia, with a long history of investing and operating in China, Eastspring believes that for many allocators the longer-term financial case for adding exposure to China is quite compelling. While this comes with headline risks given deteriorating relations with the West, the tremendous alpha opportunity is hard to ignore. As China’s influence and size within EM indices grows, we believe it may be more efficient to gain exposure through a dedicated China allocation while at the same time, creating a separate and less correlated EM ex China allocation. While still early days, there’ve been increased discussions among large public and sovereign wealth funds about making the shift and numerous managers have launched ex-China strategies to meet anticipated demand. In some cases, the decision to exclude China all together is based on opposing views of risks or given ESG concerns, in which case an ex-China allocation is also an effective solution.

While strategic asset allocation decisions have implications for China’s domestic markets, they also create “spill-over” effects on peripheral EM countries outside China, which stand to benefit from shifting allocations within an ex- China framework. Coupled with positive foreign direct investments (FDI) into peripheral EM countries resulting from diversification of global supply chains, the “China +1 effect” is creating substantive positive tailwinds for ex-China beneficiaries. With China comprising 30% of the MSCI EM index and continuing to grow, it’s arguable that it’s still under-represented within global portfolios, justifying larger, discrete allocations. China represented 5% of the MSCI EM Index 20 years ago, and at year end 2022, it stood at 32% and is forecast to hit 44% with 100% inclusion of onshore China A shares. As China’s index weighting continues to rise, attractive alpha opportunities in other emerging markets will continue to be crowded out as they have disproportionately smaller index weights. Asset owners cannot afford to miss out on idiosyncratic opportunities across EMs ex China and shouldn’t have their opportunity set limited by the benchmark.

As historically seen with ACWI ex U.S. and Asia Pacific ex Japan, when a single country dominates a global or regional index, sophisticated investors typically transition to discrete allocations to that dominant market to better optimize active risks and in turn often hire specialized asset managers within that region to generate alpha. This transformation to EM ex-China plus dedicated China is gaining traction and we believe it’s the beginning of a sustained, longer-term shift in strategic asset allocations.

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1 Eastspring Investments, 31 January 2023. MSCI Index.