English Portfolio Management

How to invest in Chinese Equities?

We cannot ignore the current relative valuation and future prospects of Chinese equities, despite the risks. Options, even if imperfect, remain an indirect exposure and a diversified investment in emerging markets.

Investing in Chinese stocks has always been a headache for private foreign investors: On the one hand, we cannot ignore the growing importance of China in the world economy. On the other hand, Chinese stocks present various problems. This article first discusses these risks, and then discusses the various ways to gain exposure to Chinese stocks.

Problems with investing in China

  • GDP growth does not equal stock market growth: The perennial disappointment of foreign retail investors in China is that the stock market performance lags or diverges strongly from GDP growth. Because of the state’s influence over key segments of the Chinese economy, foreign investors may not get their fair share of this growth. Existing companies are also selling additional shares, which dilutes the earnings of the shares. This share dilution is particularly high in Asia, reducing earnings per share as the company stops growing.
  • Lack of stock market maturity: The market is not at all efficient and not very transparent for foreign investors. The media also frequently reports market manipulation by the government and powerful individuals. Traditional passive investors (such as some Bogleheads) are even considering active management because of the inefficiency of the Chinese stock markets.
  • Weak protection for private investors: The omnipresence of the Chinese state also increases the political risk of investing in China with the threat of indirect expropriation. The interdependence and reciprocity of Chinese investors and governments holding assets in the United States (China is second only to Japan among foreign holders of U.S. debt), Europe, and Switzerland only partially mitigates this problem. In addition, legal systems and shareholder protections are not necessarily favorable to private foreign investors.

Options for exposure to China

Index tracking (emerging markets)

Anyone who has invested passively in an emerging markets index fund in recent years (using MSCI or FTSE indices) has automatically added more China exposure to their portfolios, as these indices are gradually rebuilding to include more A-shares (listed on mainland Chinese exchanges) in their composition.

  • The iShares ETFs based on the MSCI Emerging Markets (such as IEMG) currently have 33.9% exposure to mainland China and 14.8% to Taiwan, leading to an allocation to China of just under 50%. MSCI EM began including Chinese A-shares in the MSCI Emerging Markets Index in 2018 and their share had increased to 20% with the inclusion of mid-cap Chinese A-shares in 2019.
  • Vanguard VWO tracks the FTSE Index and has a larger weight in Chinese equities (Mainland China at 37.5% and Taiwan at 18.4%). If you were looking for more exposure to Chinese stocks in the future, then you would prefer the FTSE index tracked by Vanguard. Mainland China currently makes up over 40% of the Vanguard Emerging Markets Stock Index, and with the addition of mainland A-shares in the coming years, it will soon make up over 50% of the index. This is already a significant exposure to China through EM indices, next to the additional lower allocation to China among ETFs tracking developed market index.

This will continue as global and emerging market benchmarks add weight to China. Barring any significant unforeseen events, exposure to these indices will be a natural expansion of your portfolio’s China investment allocation.

Active investments

Due to the lack of transparency, some passive investors are considering active management for China. It remains difficult to assess whether this approach can beat a passive approach after fees. Navigating the waters of political intricacies is particularly difficult, especially when publicly available stocks are not in strategic segments that remain under state influence.

If an investor wants to increase exposure, he or she might consider investing in a fund like the iShares MSCI China ETF, but the TER at 0.59% is much higher than its EM diversified cousin (MSCI Emerging Markets). Active options are also too expensive at 1.15% (e.g. Matthews China Dividend Fund).

Indirect exposure to China

One of the best ways to gain exposure to the Chinese growth story is to invest in foreign companies that benefit from China’s growth, especially through high-end brands or segments where China’s growing middle class is spending.

Any diversified developed market fund therefore has partial indirect exposure to China and we do not believe there is a need to add directional bets of active management or segment-specific ETFs.

How can the retail investor invest in China?

Many U.S. investors (such as William J. Bernstein) recommend limiting their overall investments in emerging markets to 5-10%. Despite the risks, we rather agree with Burton Malkiel that the current valuation and future prospects of emerging markets relative to U.S. large caps and developed markets call for a higher allocation (perhaps one-third or more if you are young or have stabilizers in your portfolio).

Others advocate looking only at “big-name” companies (like Alibaba and Tencent): These are solid companies, but we saw in 2021 how the Chinese state is tempted to take its share of these companies’ success. While these big names reduce the risk of unfair treatment of retail investors, they still expose the investor to concentration risks (as might be the case with small-cap stock selection).

You should consider overweighting China (and emerging markets) with caution, as their growing economy can benefit the state and wealthy individuals without the fair share available to foreign investors in more liberal states. Therefore, despite the political and corporate governance risks you should be aware of, as well as the lack of access to strategic segments of the Chinese economy, an appropriate (though far from perfect) option remains a broadly diversified investment in emerging markets. A broader index provides meaningful exposure to Chinese companies (“big-name”) listed overseas and in China (A-shares).