Geopolitical tensions, a weakening growth outlook and major trade tariffs are casting a dark cloud over China’s economic future — and markets are responding.
Several funds have launched over the past two years that cut off exposure to China in favour of emerging markets (EM) with stronger growth prospects, such as India, South Korea and Taiwan.
AGF Investments Inc., BlackRock Asset Management Canada Ltd., Mackenzie Investments and RBC Global Asset Management Inc. are among the firms to launch these investment vehicles.
Portfolio managers say these funds allow investors to reap the benefits of high growth in up-and-coming economies at a time when there are growing concerns over geopolitical risks, unfavourable demographics and an extended period of weak returns in China, the world’s second-largest economy.
Chinese and Hong Kong stocks lost more than US$6 trillion in value between February 2021 and January 2024. They have since rebounded — the Hang Seng Index is up a third from its low in January and the MSCI China Index is up by 16% so far this year — but there are lingering concerns about volatility. China’s high debt levels and property crisis are also concerns.
“To me, an EM ex-China fund provides exposure to the greatest GDP growth stories left in [the emerging markets], which includes India, Taiwan, Korea and a lot of others,” said Arup Datta, senior vice-president and head of the global quantitative equity team with Mackenzie Investments.
Datta is also the lead portfolio manager of the Mackenzie Emerging Markets ex-China Equity Fund, which launched April 25 and has a management fee of 0.8%.
He said the $5.5-million fund was born out of client demand in the wake of the U.S.-led trade war with China that began in 2018, when Donald Trump was president of the U.S.
Geopolitical tensions have persisted under Biden’s administration, which recently announced major new tariffs on Chinese products including electric vehicles, advanced batteries, solar cells, steel, aluminum and medical equipment. Trump, meanwhile, has said he would impose tariffs of more than 60% on Chinese goods if he wins the U.S. election in November.
“From [2018] to now, there has been client interest in thinking of China differently,” Datta said.
The biggest country weight as of April 30 in the Mackenzie fund is Taiwan at 25.9%, followed by India at 21.6% and South Korea at 14.3%.
Datta said India’s best GDP growth is probably still to come. Analysts at Morgan Stanley expect the South Asian country to drive one-fifth of global growth in the coming decade. Meanwhile, Taiwan is a leader in semiconductor technology, which powers the electric vehicle transition, he noted.
“So, you can see why in these kinds of markets, the growth expectations would be higher … than where perhaps China is today,” Datta said.
EM ex-China funds are also gaining steam because some investors believe China merits its own allocation due to the country’s size and market depth, said Helen Hayes, head of iShares Canada with BlackRock.
“These investors can use an emerging markets ex-China ETF in conjunction with a dedicated China allocation to gain broad exposure of emerging markets and with no unintended overlap,” she said in an email.
Hayes also pointed to a recent BlackRock research paper that suggests many emerging markets could outperform what markets have already priced in. Their working-age populations are growing, providing an economic advantage over developed markets and China, where life expectancies are increasing while birth rates are declining.
The iShares MSCI Emerging Markets ex-China Index ETF (TSX: XEMC) was one of the first emerging markets ETFs in Canada to exclude China equities, launching in February 2023. Its management expense ratio is 0.31%.
The $24-million fund invests in large- and mid-cap stocks across the 23 countries that MSCI Inc. defines as emerging besides China. The top country exposures in the fund as of May 28 are Taiwan (25.1%), India (24.6%), South Korea (16.3%) and Brazil (6.3%).Financials and technology are the top sector exposures, each with more than 20% weight.
“XEMC offers investors a way to access emerging markets while maintaining flexibility for a tailored approach to investing in China,” Hayes said.
AGF Investments launched the AGF Emerging Markets ex-China Fund (Cboe: AEMX) in October 2023. The $4.8-million fund has a management fee of 0.9%. Some of its top holdings are Taiwan Semiconductor Manufacturing Co Ltd., the Franklin FTSE India ETF and Samsung Electronics Co. Ltd.
Regina Chi, vice-president and portfolio manager with AGF Investments, said AGF launched the fund because of China’s dominance in the MSCI Emerging Markets index “and the geopolitical headwinds that we were seeing with China and the rest of the world.”
Chi said EM ex-China funds allow investors to participate in secular growth within emerging markets. This includes India, where real GDP growth is forecast to expand by almost 7% in 2024 — one of the highest rates globally. There, the government is promoting onshore manufacturing, which is the production of goods within the country in which they are sold, thereby cutting costs, lead times and carbon emissions.
As a result, India makes up 21.5% of AGF’s EM ex-China fund, following closely behind Taiwan at 21.7%.
“You also have other secular stories that are smaller but are better exposed in an EM ex-China index because they have higher weight, [such as] Indonesia and Mexico,” Chi said.
She noted Indonesia is poised for high GDP growth, as it has one of the fastest-growing middle classes in the world, while Mexico is a beneficiary of nearshoring, or short-distance outsourcing, with the U.S. — a trend that’s helped Mexico replace China as the top exporter of goods to the U.S.
Although the MSCI EM index has underwhelmed over the past decade, posting net returns of 2.96% in comparison to the MSCI World index’s 8.87%, both near- and long-term catalysts suggest investors should revisit their allocation, Hayes said.
Chi agreed.
“China is facing some domestic issues as well as geopolitical tensions that will keep investors shying away from China, and so an EM ex-China fund would be a diversifier for them, especially if investors are trying to be agnostic on their home country bias, as well as if you stop believing that there is U.S. exceptionalism,” she said.
Datta said the underperformance of China’s stock market over the past few years is tipping the scale in favour of ex-China funds.
“Some people are looking at that lens who would say, ‘China has dragged down emerging market indices the last five years. I don’t want that to happen. So therefore, maybe I should invest in EM ex-China,” Datta said.
This article appears in the June issue of Investment Executive. Subscribe to the print edition, read the digital edition or read the articles online.