China Entry to MSCI Poses Risks for Investors Seeking Diversity

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The inclusion of China’s mainland stocks in MSCI Inc.’s developing-nation index would further boost the dominance of Asia in the widely followed benchmark and create a risk of lopsided exposure for investors.

The outperformance of the region’s stocks over the past five years against markets such as Brazil and Russia has helped increase their weighting in the MSCI Emerging Market Index to 69 percent, the highest since at least 1995. Hong Kong-listed Chinese companies, along with those in South Korea and Taiwan, make up more than half of the 23-country benchmark, which has about $1.7 trillion of global funds tracking it.

MSCI will decide on June 9 whether to add China’s locally traded shares in the index-provider’s equity benchmarks, a historic shift that has the potential to move billions of dollars into mainland stocks. While an inclusion would better reflect the landscape of emerging markets, the risk for investors who follow the developing-nation gauge is that their holdings become too concentrated in one region.

“You’ve got an increasing lack of diversification,” Allan Conway, head of emerging-market equities at Schroder Investment Management Ltd., said by phone from London. “One of the benefits of emerging markets is that you’ve got a large number of countries. That gives investors some diversification and good risk control. The more concentration, the less benefit you get. That’s a problem.”

Asian stocks have gained 6.1 percent this year, compared with a decline of 8.4 percent for their Latin American peers and a drop of 1.8 percent for emerging stocks in Europe, Middle East and Africa, according to MSCI’s indexes. The Shanghai Composite Index of Chinese mainland shares soared more than 50 percent.

Fast Growth

Since the end of 2011, the Asia gauge has risen 30 percent, beating the average gain of 6.7 percent in developing countries.

Asian companies have rallied as the region grows faster than other emerging economies. A collapse in commodity prices over the past year has helped reduce energy-import costs in countries such as China, India and South Korea, while hampering earnings of raw-material exporters in most of Latin America and Russia.

China, through its companies listed in Hong Kong, accounts for more than 25 percent of the emerging-market benchmark. It’s the biggest weighting in the gauge, followed by South Korea’s 15 percent and 13 percent for Taiwan, data compiled by Bloomberg show. MSCI has kept China’s so-called A shares out of its indexes due to limitations on their tradability.

Chinese yuan-denominated stocks, if added, would make up less than 1 percent of the MSCI benchmark in the initial stage. A full inclusion, which is subject to China’s continued relaxation of trading restrictions, would boost China’s weighting to 38 percent, according to MSCI.

‘Less Attractive’

“A bigger China in the EM index makes the global emerging-market universe less attractive,” Maarten-Jan Bakkum, senior EM strategist at NN Investment Partners in The Hague, said by e-mail. “It would make EM an ‘Asia-plus’ category. For investors it might be less appealing. Why buy EM if you can also buy pure Asia products?”

It is not uncommon for a benchmark to be dominated by a small group of countries because of their relative market size. U.S. companies, for instance, make up 56 percent of MSCI World Index. Investors tend to deviate their portfolios from the weightings in an attempt to beat the benchmarks.

Sebastien Lieblich, Global Head of Index Management Research at MSCI, said Asia’s heavy weightings simply reflect more investment opportunities available there.

“If the natural opportunity set based on the economic value of the companies results in China being 40 percent of the index, so be it.” Lieblich said by phone from Geneva.

Selective Investing

Asia’s weighting has increased from 49 percent in June 2008, while that of Latin America fell from 20 percent to 10 percent. This trend will continue because earnings growth in Asia outpaces the rest of emerging markets, according to Geoffrey Dennis, head of global emerging-market strategy at UBS Securities LLC.

For Henry McVey, global head of macro and asset allocation at KKR & Co., a concentrated index means investors now need to be more selective rather than blindly follow the benchmark.

“This concentration effect is not to be under-estimated,” McVey, whose firm manages $99 billion in assets, wrote in a note on May 14. “There can be a notable penalty for owning a concentrated index.”

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