Too Risky to Own, Too Big to Ignore

For long-term ETF investors, the key issue is not simply whether to own China, but how removing it changes the rest of the portfolio. An emerging-markets ex China fund is still a single bet on the broader emerging-markets complex, just with a different country mix. That means the decision shifts from China concentration to a new set of exposures that can be harder to spot at first glance.

One important question is what replaces the missing China weight. Excluding a large market often pushes more capital into other countries and sectors, which can leave the fund more dependent on a smaller set of outcomes. Investors should look closely at the index methodology, country caps, and reconstitution rules, because those mechanics determine whether the fund is broadly diversified or simply concentrated in a different way.

Sector balance also matters. When a fund removes major Chinese internet and consumer names, the portfolio often looks different across technology, financials, and materials. That may be intentional, but it can also increase sensitivity to a narrow group of industries. For investors building a strategic allocation, the question is whether this complements existing holdings or duplicates other growth- and tech-heavy exposures elsewhere in the portfolio.

Finally, newer ETF themes deserve scrutiny beyond the headline idea. Specialist products can be useful tools, but investors should still weigh fees, trading spreads, and the possibility that assets could migrate quickly into only a few dominant funds. In niche categories, that matters because liquidity and closure risk can affect how easy it is to hold the fund through a full market cycle.

Chinaโ€™s economy and stock market have fallen off their peak but still pose a conundrum for investors. They can invest in broad, diversified emerging-markets funds with their still huge China stakes and bear the countryโ€™s substantial economic and geopolitical risks, along with the vicissitudes of other developing markets. Or investors could try to cobble together collections of various regional funds that underweight the worldโ€™s second-largest economy and one of its biggest stock markets, risking a bad case of FOMO if China rebounds and takes off in ensuing years. Asset-management firms, which rarely miss a chance to devise fee-collecting solutions to such problems, in recent years have offered more emerging-markets funds that simply carve out China. Ostensibly, such funds give investors, advisors, and institutions more control over their helpings of China in the emerging-markets portions of their portfolios or the ability to skip the Middle Kingdom altogether. By mitigating one big risk, though, emerging-markets ex China funds may be courting others. Hereโ€™s a look at this relatively new, unofficial subcategory of emerging-markets strategies.

The Conundrum

In 2010, China leapfrogged India, Japan, and Germany to become the worldโ€™s second-largest economy. Over the next 10 years, its weighting in the MSCI Emerging Markets Index rose from 17.4% to an all-time high of 42.8% in October 2020. Slowing economic growth and a retreating stock market reduced that stake to 26.1% by the end of 2023, but China remained the indexโ€™s largest single country. Some investors arenโ€™t comfortable having so much money in China, given its murky property market, challenging demographics, and penchant for intervening in the affairs of its largest public companies.

The Answer?

To accommodate wary emerging-markets investors, fund companies have launched 16 emerging-markets ex China funds since 2021, bringing the total to 21. How do these funds differ from the typical diversified emerging-markets Morningstar Category peer? The first difference is these portfolios tend to own more of other developing countries such as India and Taiwan, which arenโ€™t exactly free from China-related risks. India, a democracy, and China, a communist country, are rivals, and the Chinese government and military openly plot and maneuver to make Taiwan part of the mainland again. Some of emerging-markets ex China fundsโ€™ most popular holders include Taiwan Semiconductor Manufacturing TSM, PT Bank Central Asia BBCA, and Samsung Electronics SMSD. Taiwan Semiconductor is often a top holding among diversified emerging-markets funds, which also own big Chinese companies such as Tencent Original Postinx/tcehy/quote" shape="rect">TCHY, Alibaba BABA, and Meituan. Emerging-Markets ex China funds look much different than their peers who can invest in China. Source: Morningstar Direct. Data as of Dec. 31, 2023. Emerging-markets ex China funds tend to have more exposure to Brazil and Mexico, which have their own economic, social, and political downsides. Both countries have been accused of having corrupt governments, which have led to political uprisings. Emerging-Markets ex China funds have to invest more heavily in countries such as India and Taiwan to make up for their lack of China exposure. Source: Morningstar Direct. Data as of Dec. 31, 2023. Emerging-markets ex China funds also tend to own fewer consumer cyclical companies because they take a pass on Chinese giants such as Alibaba, Meituan, and Tencent. As a result, these funds tend to have more money in technology, financial services, and basic materials firms. Indeed, the typical emerging-markets ex China fund has close to half its assets in technology and financial stocks, which courts sector risk. EM ex-China funds tended to have more exposure to technology firms but less exposure to consumer cyclical firms than their emerging market peers that invest in China.

The Response

These funds are still new, but they have attracted flows. In 2023, emerging-markets ex China funds took in $5.6 billion. IShares MSCI Emerging Markets ex China ETF EMXC, which in 2023 took in $4.8 billion (about 82% of the groupโ€™s flows), was the most popular choice. The timing of the fundsโ€™ launches has made them look good. In 2023, Chinese equities were among the globeโ€™s worst-performing stocks. The average emerging-markets ex China fund gained 21.8% in 2023, which was far more than the typical diversified emerging-markets category peerโ€™s 12.0% gain. Moreover, all 15 of the funds with full-year 2023 returns ranked in the top quintile among its category peers. The iShares MSCI Emerging Market ex China ETF was the main beneficiary of investors' increased interest in these funds. Source: Morningstar Direct. Data as of Dec. 31, 2023. The average emerging-markets ex China fund also is a little cheaper than the average diversified emerging-markets category fund. Thatโ€™s because seven of the 21 funds available are exchange-traded funds, which tend to have lower expense ratios than traditional mutual funds. Source: Morningstar Direct. Data as of Dec. 31, 2023. Emerging-markets ex China funds tend to be cheaper than other emerging-markets peers.

Will They Last?

Itโ€™s not clear whether these funds are just another flash in the pan or if theyโ€™re here to stay. If history is any guide, there could be a shakeout. Japan has long posed a similar problem for the MSCI EAFE Index and funds that use it as a benchmark; the island nation currently makes up nearly a fourth of the benchmark and has taken up more in the past. Since the first launch of an Asia ex Japan fund in 1977, asset managers have launched 114 such funds in the United States. As of December 2023, just 25 remained. In fact, nearly half the Asia ex Japan funds didnโ€™t make it to their fifth birthday. Source: Morningstar Direct. Data as of Dec. 31, 2023. Alive funds also recorded in data. Asia ex-Japan stock funds rarely make it past their 10th birthday.

Are They Worth It?

Emerging-markets ex China funds help solve some problems but create others. On one hand, they allow investors to minimize or eliminate China exposure, but they increase helpings in other developing markets with their own issues. Not only is this risky, but investors must consider how much, if any, China exposure they want, which can complicate portfolio management and leave a wider margin for error. Only time will tell whether allocating nearly a fourth of emerging-markets assets in China proves to be a good idea, but itโ€™s also risky to go against the wisdom of the markets. If history is any indication, investors should approach these funds with a healthy dose of skepticism.
https://www.morningstar.com/funds/too-risky-own-too-big-ignore

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