Index Capital Insights Issue #2

In terms of the forward-looking opportunity set, US investors face a stark contrast across accessible global stock markets. Developed and emerging international stock markets are set up to likely deliver significantly better real returns in the coming decade than the domestic US market. This has been the case for quite some time, so this is not a prognostication with respect to timing, but for long-term investors a neutral to overweight allocation to international equities is warranted given current pricing across global stock markets. That said, investing in international equities entails an array of additional risks, none of which are trivial.

Within the EM complex, China stands clasped with Taiwan and the United States in a destructive grasp of looming threat. How this geopolitical drama eventually unfolds is a big source of uncertainty for US emerging markets investors, and it could ultimately impact all investors for generations. During the twentieth century, investors in Chinese stocks faced a total bust as the market was shuttered. However, markets do not have to completely close to all investors for foreigners to be shut out and forced to sell at fire-sale prices.

US sanctions on Chinese companies over the past several years are a case in point. All major index providers dropped index constituents when the companies were identified by the US Treasury’s Office of Foreign Assets Control (“OFAC”) as sanctioned targets of US foreign and/or national security policy. Interestingly, these same providers often sponsor indexes intended for domestic Chinese market participants that include sanctioned companies, but global indexes intended for use by US or European market participants exclude companies sanctioned by these governments, effectively shutting out investors in the country imposing sanctions. In a scenario of open hostility between the US and China, US sanctions on Chinese companies could be much broader than recent history, effectively clamping off access to new, or continued, equity investment in these companies by US investors.

On the bullish side of the debate, Chinese equities have been so battered over the past several years that some banks and advisors are advocating global investors re-enter the market. China’s stock market cyclically adjusted PE ratio (CAPE?), as calculated by Barclays Research[1], stood at about 10 as of year-end ’23. I have sympathy for the valuation argument, but a compelling CAPE? in a communist authoritarian country with relatively short stock market history is not as convincing as it would be in some other markets. Betting on Chinese stocks by US investors implies a sanguine outcome to the geopolitical challenges, as well as at least a partial resumption of China’s previously impressive growth trends. Note that among possible peaceful outcomes is living with China’s threat to Taiwan in perpetuity. If China were to diminish its saber rattling and war preparations, the immediate threat could cool down; investors would be faced with the challenge of discounting a potential future threat but could earn good returns for years to come.

Given the significant uncertainty, I find a constructive approach in allocating capital to EM’s, and China in particular, is to remain highly risk aware while finding a way to gain meaningful exposure to these attractively positioned markets. Several ETF and mutual fund providers have introduced EM ex China funds in recent years. The Financial Times recently stated that net US flows into EM ex China ETFs “more than tripled to $5.3 billion last year…”. However, these products generally include Taiwanese stocks. If one buys them with the objective of mitigating geopolitical risk stemming from China’s threat to Taiwan, they may not be entirely effective. The largest stock in Taiwan’s market is Taiwan Semiconductor Manufacturing Company (TSMC, NYSE Ticker: TSM), a strategically important semiconductor fabrication company. If China were to prevail in a war to overtake Taiwan, a plausible, if not probable, scenario is that it would target TSMC for its own government’s use and control.

Therefore, my preferred investment framework is to overweight EM stocks as a group but to underweight both China and Taiwan within the allocation. Given total global EM stock market weight of about 10%, a 60/40 portfolio with market cap weights would have an EM position of about 6%. If one wanted to overweight EM stocks by 4% in such a portfolio to a total commitment of 10%, the allocation could utilize a broad-based index fund combined with a custom EM basket to overweight EMs at the portfolio level while underweighting China and Taiwan. At a high level, the EM allocation might look like the following.

Table 1

Underweighting some countries implies overweighting others. To form a market cap weighted custom EM basket, you can select from the top countries in the Vanguard FTSE Emerging Market ETF (VWO), exclude China and Taiwan, and proportionally weight the remaining countries by market cap. As Table 2 shows, this results in a significant overweighting to India (when combined with India’s weight in the core EM fund), but subsequent deviations from proportional market cap can be made for a variety of reasons. iShares country ETFs can be used to implement the custom basket. Here is an example of a proportional market cap weighted custom basket:

Table 2

The net expense ratio (NER) of the custom EM basket is 62 bps, which is 54 bps higher than VWO’s NER of 8 bps. That seems like an expensive way to simply omit China and Taiwan. But the additional expense is limited to 5% of the portfolio, so it equates to only an additional 3 bps at the portfolio level.

Note that, between the broad EM stock fund and the custom EM basket cited in Tables 1 and 2, we are mixing underlying index providers, which may often lead to detrimental effects in a portfolio. For example, if you were to mix FTSE’s EM index with MSCI’s developed markets (DM) index, an unintended consequence might be that Korea is omitted from your international stock allocation. However, in this case we are simply using iShares’ MSCI-based country ETFs to overweight some of the countries represented in Vanguard’s FTSE-based EM fund(s).

The potential for gaps and overlaps extends to active funds, too. For example, if you use Vanguard’s FTSE-based EM and DM core funds but want to tilt your EM exposure towards the value factor with a fund benchmarked to MSCI’s EM Value Index, it would probably include Korea. There is nothing wrong with this, but you should be aware of the inconsistency between MSCI’s and FTSE’s treatment and may need to adjust positions to ensure consistency with your investment policy.

When using a core EM fund with a custom EM basket, there are several levers that investors may use to precisely target the level of country-specific exposure within the EM allocation. First, the split between broad EM and the custom EM basket can be fine-tuned. Then, within the custom EM basket, tilts can easily be made to accommodate general risk aversion, total single-country risk, personal preferences, or perceived opportunities. For example, US investors may want to overweight Mexico relative to its proportional market cap weight because they anticipate above trend economic growth due to US near-shoring of its supply chains. Or, if an investor does not wish to overweight a despotic country like Saudi Arabia, that market may also be omitted from the custom EM basket.

The iShares MSCI-based country ETFs offer a great tool to customize international equities exposure, even in combination with other benchmark families and product lineups. The relative outperformance of the US stock market will likely turn at some point, and investors who position themselves for that eventuality may benefit from a once in a generation opportunity.

[1] See https://indices.cib.barclays/IM/21/en/indices/static/historic-cape.app