Investors pile into emerging-market funds that cut out China

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Investors are piling into emerging market funds that exclude China despite a recent blistering rally in Chinese stocks, amid concerns over escalating tensions between Beijing and the west.

Investment firms told the Financial Times that clients increasingly see the world’s second-biggest economy as too large or risky to manage alongside other developing economies such as India, leading to one of the biggest shifts in emerging markets investing in decades.

Franklin Templeton became the latest manager to launch a so-called “ex China” emerging markets vehicle on Tuesday, adding to a class of funds that has increased assets by 75 per cent this year to more than $26bn, according to data from Morningstar.

“When investors are keen to avoid a certain sector or region, the industry is happy to oblige,” said Michael Field, European equity strategist at Morningstar. “This has certainly been the case with funds that have excluded China from their make-up.”

China is classed as the world’s largest emerging market, with its companies making up a quarter of a benchmark MSCI index for developing-economy stocks.

That weighting is down from a peak of over 40 per cent during the global pandemic. But it is still considered too large by many investors concerned that it is drowning out exposure to more promising economies, or is saddling them with risk over tensions between China and the west.

This has led to “what is essentially a new asset class” as investors carve out Chinese stocks into separate allocations and build portfolios that allow greater exposure to India, Taiwan and other markets, said Naomi Waistell, a portfolio manager at Polar Capital, which also has an ex China fund.

A surge in Chinese shares since Beijing unveiled stimulus measures last month has not changed this calculus, as the country’s volatile stocks have become a bet on the scale of government action, Waistell added. “China is a different type of market — it does have those idiosyncratic risks, and perhaps needs to be looked at by specialists.”

So-called “ex China” equity funds have received $10bn of net inflows so far this year, according to JPMorgan — outstripping the total amount of money that has gone into broader emerging market equity funds. The number of such funds globally has nearly doubled to 70 in the last two years, according to Morningstar data.

Some investors are also worried about the potential for further sanctions against Chinese companies, partly because of memories of the collapse of investments in Russia after Moscow’s invasion of Ukraine, fund managers said.

Countries in Europe have clamped down on Chinese entities accused of supporting Russia’s war effort, while the US has proposed restricting investment into parts of China’s tech sector.

Larry Fink, chief executive of BlackRock, told a conference in Berlin this month that China was the “biggest supporter” of Russia “and that has to be at least discussed”.

Fund managers say political reasons for going “ex China” are mostly still concentrated among US investors, where large pension funds have axed exposure to the country citing national security risks.

Last year trustees of the Missouri State Employees’ Retirement System voted to sell Chinese shares. Vivek Malek, the state’s treasurer, said that “investments in China simply carry a level of risk that is contrary to the interests of our retirees”.

Florida’s governor Ron DeSantis signed a law earlier this year requiring the state’s investment board to offload existing direct holdings in China “to ensure foreign adversaries like China have no foothold in our state”.

“Overall US investors have a more negative view of China, while Europeans are more pragmatic and in the middle,” said Thomas Schaffner, who manages emerging-market stock funds at Swiss asset manager Vontobel.

Some investors have questioned whether moving emerging market investments to an “ex China” basis alone can mitigate political risks.

Yves Choueifaty, founder of TOBAM, a manager that seeks to cut out “autocracy risk” in investments, said this risk also lay in shares in companies in developed economies that had their largest market in China.

“Russia and China are the same qualitatively speaking, but quantitatively speaking, the exposure to China is simply enormous,” Choueifaty added.

Additional reporting by Brooke Masters in New York