- As China further opens its financial markets, some investors appointed a dedicated program to look after the China-related investment opportunity set.
- Compared with an incremental setup, a “refinement” configuration of an equities program circumvents the need to completely change existing investment policy.
- Despite their relatively high risk over a long-term sample period, Chinese equities historically demonstrated consistent diversification benefits within a global equity portfolio.
As China further opened its financial markets, some investors established dedicated programs for China allocations. Given the complex nature of China’s market landscape, however, doing so is no simple task.
Some have chosen to include such assets within nontraditional allocation buckets such as “alternative investments” or “absolute-return investments,” while others may consider a more aggressive approach and create a separate allocation bucket for China that includes multiple asset classes. While a dedicated China program can be applied across all asset classes, both public and private, in this blog post, we focus on public equities as an example.
We start by looking at what some term a “refinement” approach, which introduces a China element into respective equity sub-asset-class programs without the need to significantly disrupt an existing investment policy.
Examples of a ‘Refinement’ Dedicated-China Equity Allocation Using MSCI Indexes
Potential Financial Impacts of Incorporating a Dedicated-China Equities Program
Regardless of the chosen approach, there are, of course, potential opportunities and risks to a dedicated China allocation. While this applies across asset classes, here we focus on investors’ equity portfolios for simplicity’s sake, and the fact that the rise in China’s economic power may have significant financial implications for investors’ equities portfolios. These include potential changes in fundamental growth expectations and return/risk profiles of the asset class.
We begin by looking at the relationship between China and other regional equity markets, using the MSCI China Index as a proxy. The exhibit below shows that the MSCI China Index outperformed the MSCI Emerging Market ex China Index and the MSCI Developed Markets ex USA Index during both shorter (December 2019 to December 2020) and longer (December 2009 to December 2020) sample periods, though it did so with higher risk levels over the longer period. Additionally, while the MSCI China Index underperformed the MSCI USA Index during the longer sample period, it outperformed during the shorter one with less risk.
Historical Return and Risk of MSCI Indexes Over Long- and Short-term Periods
Long-term sample period: December 2009 to December 2020; short-term sample period: December 2019 to December 2020.
Despite its relatively high risk over a long-term sample period, China would have provided diversification to a global equity portfolio in both the near and long term. Over the last 10-plus years through December 2019 and during calendar year 2020, the MSCI China Index displayed lower correlations with global markets, as represented by the MSCI ACWI Index, compared with those of other equity markets. As a result, a dedicated China allocation may have potentially reduced risk from a total portfolio perspective.
To demonstrate the potential effect of this diversifications, we simulate a hypothetical EM equity portfolio’s allocations to a dedicated China and a dedicated China A program based on respective MSCI market-capitalization-weighted indexes as of December 2020.
As shown in the exhibit below, we found that the minimal ex-ante total risk of the EM portfolio was achieved when around 60% was allocated to the MSCI China Index or around 30% to the MSCI China A Index in the dedicated China and dedicated China A programs, respectively. By comparison, China and China A shares’ weights in the MSCI EM Index were 39.1% and 4.8%, respectively, as of Dec. 31, 2020.
Total Risk with Different Allocations to MSCI China and China A Indexes
The ex-ante total risk is calculated using the MSCI Barra Global Equity Model (GEMLT), as of Dec. 31, 2020.
China provides global investors a unique set of opportunities and challenges as they evaluate a potential dedicated investment program and how to approach asset allocation from policy configuration to portfolio implementation.