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.

Health Savings Account Basics

Due to the rising cost of health care expenses, many employers have included High Deductible Health Plans (HDHP) in their benefit programs. A High Deductible Health Plan usually has a lower monthly premium than a traditional health insurance plan. However, the deductibles for this type of plan start at $1,400 for an individual or $2,800 for a family. To offset this cost, participants in these plans usually have the option to save their own money through a Health Savings Account. So, what are Health Savings Accounts and how do they work?

A Health Savings Account (HSA) is a savings account into which individuals can contribute money on a pre-tax basis to pay for qualified medical expenses. This type of account is said to have a “Triple Tax Advantage” which makes opening and funding one very attractive. The first advantage is that deposits into the account are exempt from Federal Income Tax. In addition, any investment gains and interest inside the account are not taxable. Lastly, if the funds are ultimately used to pay medical expenses, then the withdrawals from the account are also non-taxable. HSA annual deposits for 2020 are limited to $3,550 for an individual and $7,100 for a family. Those over 55 years of age may deposit an additional $1,000.

What happens if the funds are needed for a non-covered expense like elective surgery or a new car? Withdrawals for non-covered expenses will be subject to Federal Income Tax regardless of when they are taken. However, non-covered withdrawals before 65 years of age will be charged an additional 20% penalty fee.

It is important to note that covered expenses are not required to be reimbursed as they are incurred. This means that, if you can afford to wait to reimburse yourself and maintain the receipts/documentation, you can reimburse yourself at a later date for any expense incurred while your HSA was open. This allows you flexibility and control over when withdrawals are taken, which could potentially allow your money to grow even more.

*This information is not all encompassing. Please contact Clear Prosperity or your tax advisor to determine if a HSA is right for you.

2020 Mid-Year Market Review and Outlook

Review of the First Half of 2020:

The first half of 2020 saw one of the fastest market crashes in history followed by a rapid bounce back that defied many prognosticator’s forecasts. Stock markets around the world fell double digits in the first quarter 2020 (Q1) only to regain a large portion of the losses in the second quarter (Q2.) The table below shows returns for the major indices for the first half of the year.

IndexYear to Date Return Through June 30
S&P 500 (U.S. Large Caps)-3.08%
Russell 2000 (U.S. Small Caps)-12.98%
All Country World-6.19%
International Markets (MSCI EAFE)-11.07%
Emerging Markets (MSCI EM)-9.67%
U.S. Aggregate Bond6.27%

The only index to post a positive return was the U.S. Aggregate Bond Index. The return was mainly driven by the Federal Reserve Bank’s (Fed) intervention in the bond market, including the unprecedented action of buying bond Exchange Traded Funds (ETFs.) The S&P 500 gained 20.54% in Q2 yet ended the first half of the year down 3%. The Europe, Australasia, and Far East Market (EAFE) and Emerging Markets ended down 11% and 9.7% respectively. The All Country World Index, a measure of all stock markets, finished down 6%. It was buoyed by U.S. Large Cap Stocks which account for approximately 60% of the index.

While indexes are often reported on and discussed, they do not show the entire story. Markets are divided into sectors, or a grouping of companies with similar economic characteristics.  The S&P 500 is divided into 11 different sectors. Examining the returns of these sectors reveal a stark contrast between the winners and losers. The two tables below highlight the top and bottom performing sectors.

Top Three S&P 500 Sector Returns
SectorYear to Date Return Through June 30
Information Technology14.95%
Consumer Discretionary7.23%
Communication Services-0.31%
Bottom Three S&P 500 Sector Returns
SectorYear to Date Return Through June 30

Only two of the 11 sectors produced positive results. As populations worldwide were mostly confined to their homes, many individuals and businesses invested in additional technology in a bid to keep operations while working from home. Information Technology and Communication Services continued their strength from 2019 and stayed within the top three sectors. Energy continued its losing streak. Energy has been the bottom performer for 2014, 2015, 2018, 2019 and, now, the first half of 2020. The Energy sector is down 41% since 2014.

Preview of the Second Half of 2020:

At time of this writing, earnings season is just beginning. Company earnings for Q2 will be the first that fully reflect the impact that the COVID virus has had on companies. While past earnings will have some importance in terms of stock price, the company’s guidance regarding expected earnings for Q3 will be more impactful.

We believe areas to avoid going forward are banks and real estate (REITs), especially those with significant mall, commercial property, or restaurant exposure. Banks will be hampered by near zero interest rates and a lack of demand for loans. REITs will face missed rental payments, low occupancy, and lower rental prices. Restaurants will have to manage decreased demand and COVID related restrictions.

Stocks that we think have investable potential are technology, after a pullback, infrastructure plays and targeted energy companies. Technology has been on a tear for the past year and a half. The virus has done little to impact their earnings and, one could argue, the virus has actually increased demand for technology products. Infrastructure stocks are trading at attractive valuations and should benefit from increased government spending. We believe that Government spending will be required to help keep the domestic economy running. Energy stocks, specifically large oil, are appealing due to low valuations, healthy balance sheets which are flush with cash and the bounce back of oil prices. These factors will allow the larger oil companies to selectively acquire smaller energy companies at attractive prices. Chevron’s recent purchase of Noble Energy for $5 billion is a good example.

Overall, stocks to emphasize for Q3 and the remainder of the year are those that have a high fundamental quality factor—a strong balance sheet, a history of revenue and earnings growth and a high return on equity.

A Primer: Mutual Funds and Exchange-Traded Funds

Mutual funds and exchange-traded funds are common investment products for retail and institutional investors. 

The first mutual fund, the Massachusetts Investors Trust, was created in 1924. From 1924 until the mid-1970s mutual funds were a niche product. It was not until The Vanguard Group established the first retail index fund in 1974 that assets invested in mutual funds began to grow and became mainstream. As of the end of 2019, worldwide mutual fund assets totaled $55 trillion. 

Mutual funds can generally be classified into two types: passive index funds and actively managed funds. Passive index funds track a specific index such as the S&P 500 or the Russell 2000. Actively managed funds are usually classified by the type of investment strategy of the manager. Examples include domestic large-cap growth, investment grade bonds or international value. The manager of the fund will buy and sell stocks or bonds that the manager believes will produce positive returns and that are suitable based on the mandate of the fund.

An exchange-traded fund (ETF) is an investment vehicle that trades on a stock exchange and can be bought and sold during market hours. The first successful large-scale ETF launched in 1993, the SPDRs (or Spiders), which tracked the S&P 500 (Ticker: SPY). Additional ETFs that tracked the Dow, the Diamonds (Ticker: DIA), the NASDAQ 100, the ‘cubes’ (Ticker: QQQ), followed. 

Most ETFs are passive and track a specific index or sector. There are domestic equity, international equity, bond, commodity and currency ETFs. The growth of the ETF market has been 25% annually over the past decade. Over $5 trillion was invested in ETFs at the end of 2019. 

The matrix below summarizes some of the similarities and differences between mutual funds and ETFs. 

ETFsMutual Funds
Passive Index Options

Fixed Income Index Options

Actively Managed Options
Sector-Specific Index Options

International and Country-Specific Index Options

Low Expense Ratios for Passive Index Options
Lower Fees
Superior Tax Efficiency
Transparency of Holdings
Throughout the Day Trading
Throughout the Day Pricing