Christopher Langner is a markets columnist for Bloomberg Gadfly. He previously covered corporate finance for Bloomberg News, and has written for Reuters/IFR, Forbes, the Wall Street Journal and Mergermarket.

Let's celebrate that MSCI is not in a hurry to include shares of Chinese companies traded in Shanghai and Shenzhen in its emerging markets index, a step that would suddenly increase investors' exposure to the swings of one of the world's most volatile markets. 

A Bit Smoother
While investors in the MSCI China, which has Hong Kong-traded Chinese stocks, had their share of volatility, it was less than that experienced by buyers of Shenzhen and Shanghai equities
Source: Bloomberg
* Values indexed to Apr. 6 2011 for comparability

They are already unduly subjected to that volatility. China is the biggest component of the MSCI Emerging Markets index. Almost 20 percent of the constituents are domiciled in the world's second-biggest economy. They're all listed in Hong Kong, however, where trading is a tad more rational. Actually, if companies with headquarters in Hong Kong are included in the tally, almost one-quarter of the index members are accounted for.

Considering the size of the Chinese market -- the Shanghai and Shenzhen composites have a market cap of 45 trillion yuan ($7 trillion), almost four times that of the Russell 2000 index in the U.S. -- it's safe to assume that the addition of onshore shares would increase significantly the country's weight in the index. That would add to the list of imbalances already in place.

Granted, China's sheer size and heft justifies a bigger chunk of any emerging-markets index. However, that may unbalance an index that is already far from perfect. As it stands, MSCI gives South Korea and Taiwan, for example, too much exposure. The nations are respectively the second and third biggest components of the index, with weights of 15.6 percent and 12.4 percent.

Skewed
Countries like South Korea, Taiwan and South Africa have more weight in the MSCI Emerging Markets Index than their economies warrant
Sources: Bloomberg, MSCI, World Bank

The MSCI indexes consider the universe in which international investors can play, and that may explain the heavier weight of smaller but more open economies such as Taiwan and South Korea. Ultimately, though, the index should reflect the risks investors seek when they want exposure to emerging markets.  

The emerging-markets index might as well be called the MSCI Asia, as the region accounts for more than 70 percent of its market cap. Most stock markets in Asia-Pacific tend to be correlated with China, so buyers of the MSCI Emerging Markets are already heavily exposed to the country's fortunes. 

What Diversification?
The correlation between the MSCI Emerging Markets Index and the CSI 300, which has the biggest companies listed in Shanghai and Shenzhen, already hovers around 50 percent
Source: Bloomberg

They've been lucky so far to avoid the violent swings suffered by investors in Shanghai and Shenzhen, because they're buying China by proxy through Hong Kong. Yes, they missed a huge profit opportunity before the market tanked last year. They also avoided huge losses as trillions were wiped out. 

China does need to be represented in portfolios according to its weight in the world. Still, diversification is the most basic investment tenet and the kind of thing people look for when they choose a broad index rather than a single market. This suggests there can only be so much of a country in an index. And right now, let's agree, the MSCI Emerging Markets has enough China.  

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Christopher Langner in Singapore at clangner@bloomberg.net

To contact the editor responsible for this story:
Paul Sillitoe at psillitoe@bloomberg.net