How Much China is in Your Fund?

While the Chinese economy grew 7.0% in the second quarter, signs of slower growth in July and actions by the Chinese government to devalue the yuan have caused investor concerns. For many investors, direct exposure to China is obtained through diversified emerging market mutual funds and ETFs.

Chinese retail sales rose 10.5% in July from the year earlier, according to the National Bureau of Statistics, following June's 10.6%rise. Industrial output, meanwhile, grew an annualized 6.0% in the month, lower than the 6.8% increase in the previous month.

In addition, fixed-asset investment, a key economic driver, expanded 11.2% in the first seven months of the year from the year-earlier period compared with an 11.4% gain between January and June. These metrics, while still incredibly strong compared to most countries around the world, offer downside risks to 7%-plus GDP growth investors have long expected.          

Vanguard FTSE Emerging Markets Stock index (VWO) is the largest emerging market ETF or mutual fund share class with $44 billion in assets. VWO recently had 28% of assets invested in China, more than its investments in its next two largest countries combined, Taiwan (14%) and India (12%). The ETF, which tracks a FTSE Russell index, has a 0.15% expense ratio.

Meanwhile, iShares MSCI Emerging Markets (EEM), which has $24 billion in assets, is a little more diversified at the country level than VWO. Chinese equities comprised 24% of assets, while South Korea (14%) and Taiwan (12%) are next.

The ETF, which tracks an MSCI index, has a 0.68% expense ratio. A smaller yet increasingly popular iShares Core MSCI Emerging Markets (IEMG), which tracks a more multi-cap index, has a 0.18% expense ratio. All three emerging market ETFs have negative technical indicators, according S&P Capital IQ ETF research.

china exposure of leading emerging markets ETF

Since iShares and Vanguard track indices from different providers, their exposure is tied to what that provider considers a developed or an emerging market. Since 2009, FTSE has classified South Korea as a developed market, based in part of the country’s relatively strong economic position. Meanwhile, in 2014 MSCI removed South Korea from its list of countries under review for reclassification to a developed market from an emerging market.

In June, Vanguard announced that it will soon begin transitioning to a new FTSE index that will ultimately scale up to a 5.6% weighing in China A-shares that would be separate from the existing 28% stake in China H shares. China-A tend to be issued more by local companies and the shares are only available to qualified foreign investors through regulated systems.

In late 2014, China began providing additional yet limited access to this market though there are quotas and regulatory approval for asset managers. As of mid-August, Vanguard has not announced when it would begin gradually adding in A-shares.

Though passive index based funds such as the above ETFs and Vanguard Emerging Markets Index Fund (VEIEX) are at the mercy of the index’s weighting in a country such as China, active mutual funds are not. Management can choose to over- or underweight a country based on fundamental and valuation attributes.

Fidelity Emerging Markets Fund (FEMKX), an actively managed that uses MSCI as its benchmark, had 16% of assets in China and 13% in India at the end of June. In commentary on the fund’s website, Fidelity said that it was underweighted to China as the fund did not own a trio of large-cap China-based banks that are all top-10 securities in the index. Manager Sammy Simnegar and team have concerns about the high numbers of nonperforming loans Fidelity believes are held by Chinese banks, as well as the headwinds to loan growth represented by the decelerating Chinese economy.

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