Ring Around China

How to invest in Emerging Markets and Asia without direct exposure to China

Diversifying risk while enhancing return has usually involved investing in foreign countries especially in the emerging markets. Investing in Asia offers an investor both geographical diversification and access to high GDP growth countries. The International Monetary Fund estimates that emerging market economies will grow by 6% this year – a rate much greater than those of the U.S. and Europe. The first mutual funds and exchange traded funds (ETFs) that focused on these regions were created in the early 2000’s. Since then, assets invested in emerging markets have grown by an estimated $50 billion annually.

Most investors are unaware that due to the size of the Chinese economy with relation to its’ neighbors, most mutual funds and ETFs allocate an oversized portion to China. For instance, the Vanguard FTSE Emerging Markets ETF (VWO) is allocated 36.9% to China while the iShares MSCI Emerging Markets ETF (EEM) is allocated 34.4% to China.

Should China be avoided? We believe so and have changed our investment models accordingly. For the time being, we find China to be “un-investable.” In the past twelve months, the government has toughened regulations which has created a great deal of uncertainty in the business environment. Many of the largest publicly traded companies have a negative return year-to-date: Alibaba (BABA) -37%, Baidu (BIDU) -29%, Tencent Holdings (TCEHY) -14%, Xiaomi (XIACF) -41% and China Construction Bank (CICHY) -10%. The iShares China Large-Cap ETF, which is comprised of the 50 largest Chinese stocks, is down -13% over the same period. Additionally, the iShares Asia 50 ETF (AIA) is down -9% and holds 43.6% of its assets in Chinese equities.

Additionally, cracks in the Chinese real estate market have opened. Most noticeably among the over-leveraged real estate project developers. China Evergrande Group (EGRNF) and Modern Land (HK: 1107) are experiencing a debt crisis. We believe missed interest payments, debt defaults and restructurings should be expected. While the ultimate extent of the damage is currently unknown, it adds to our concern regarding direct investment in Chinese companies. Historically, the Chinese government would step in and support firms in financial trouble. This is no longer the case as evidenced by Evergrande’s billionaire founder, Hui Ka Yan, being forced to use his personal wealth to fund the company. Of note is the fact that Evergrande is the largest issuer of emerging market high yield debt.

Clear Prosperity recently assessed countries outside of China, including South Korea, Japan, Philippines, Thailand, Vietnam, Indonesia, Malaysia, Taiwan, India, and Singapore. Each country was evaluated based on its political stability, GDP growth rate and political and business relationship with China. Each country was required to have a suitable ETF to express the attributes each country was evaluated on. After screening, Singapore, Vietnam, and Japan were selected as the preferred investable countries. India and Thailand are on “watch list” status.