A modest trade deal can’t mask major problems between Washington and Beijing, but despite those tensions, Americans are unwittingly increasing their exposure to Chinese stocks and bonds
As officials from the United States and China navigate not only a trade war but also growing geopolitical competition—as well as a clash of values on issues such as Hong Kong, Taiwan, and Xinjiang—an incongruous trend is accelerating: Americans are unwittingly becoming more heavily invested in Chinese companies and government securities.
Surveys show that 55 per cent of Americans own stocks, mostly relying on professionally managed pension funds, mutual funds, or exchange-traded funds (ETFs) to run their current investments and retirement accounts. Among those investments, a substantial 20 per cent or more is generally allocated to international equities, usually in a mix of both developed and emerging markets. But while it is well known that both actively managed and index-based funds have global allocations, one trend that has developed under the radar is the fact that the weight of Chinese companies within emerging market allocations has grown dramatically in the last year, partly because of technical changes made by the three major index providers—MSCI, FTSE Russell, and S&P Dow Jones.
In 2019, nearly $400 billion of new foreign investment into Chinese equities was driven by changes in allocations within benchmark indexes, with American investors accounting for more than a third of these massive portfolio flows. Similarly, global bond indexes that have started adding Chinese government bonds to their benchmarks accounted for an additional investment flow of more than $100 billion into China. Put together, these major shifts in fund allocations could automatically grow US portfolio investment in Chinese companies and government securities to more than $1 trillion by the end of 2021, without the active consent or knowledge of most Americans.
This dichotomy—of Americans investing more in Chinese companies even as US policies aim to punish China for its trade practices—poses significant risks. Not only will Americans' portfolios become potentially too exposed to a single economy, but they will also be allocated to one that could be subject to US sanctions or Chinese government controls. To manage these and other inherent risks, US investors need to take a closer look at what is inside their professionally managed portfolios. Fiduciaries, investors, and their asset managers should look to similar historical market anomalies—such as with Japanese stocks in the late 1980s and the previously high weighting of Mexico, Malaysia, South Africa, and Taiwan in emerging markets—and consider alternative index construction approaches that moderate the investment concentration of China in their portfolios.
Since around the middle of the last decade—well before its trade spat with the United States became a regular feature of news headlines—China was already the largest component of the main emerging market indexes.
As Beijing steadily lifted what used to be strict restrictions on foreign portfolio investment, the major providers of benchmark indexes embarked on a historic inclusion of locally listed Chinese companies within their emerging market listing
As Beijing steadily lifted what used to be strict restrictions on foreign portfolio investment, the major providers of benchmark indexes embarked on a historic inclusion of locally listed Chinese companies within their emerging market listings. Those inclusions are accelerating—as announced to the financial community in early 2019—despite the new public policy environment of increased US economic and geopolitical tensions with China.
As index-based investments surge—for example, now representing more than half of all new mutual fund inflows—the influence of global index providers has grown considerably. MSCI, FTSE Russell, and S&P Dow Jones collectively guide more than $20 trillion in global equity assets. The MSCI Emerging Markets Index, which guides more than $1.7 trillion in investments in 26 developing countries, completed a major inclusion of locally listed Chinese stocks at the end of November, which increased China's total weight to more than 34 percent of the index as of January 2020—an unprecedented proportion for a single country. Similarly, the FTSE Emerging Index, the benchmark for nearly $1 trillion in assets, has recently increased its allocation to China to more than 37 percent, in turn impacting emerging market portfolios from Vanguard, the largest manager of mutual funds for American individual investors as well as others. S&P Dow Jones also has an emerging market index that now has approximately 37 percent of its investments allocated to Chinese companies. Each of these providers of flagship emerging market benchmarks have indicated plans to further increase the weighting of locally listed Chinese equities in the next five years. When these added allocations are enacted, China's projected weight in emerging market indexes will rise toward 40 percent or more by the end of 2022. This added exposure to China will have knock-on effects. Other international equity indexes, which follow the allocations of popular emerging market indexes, and into which many American pension funds invest money, will also automatically tie a growing share of their savings to China.
Similarly, global bond indexes used by fixed income investors in the United States have a growing exposure to China. The International Monetary Fund (IMF) estimates $300 billion in increased index-driven bond investments in China by 2022.
Put together, the newly increased portfolio investments in China—and the prospects of further increases —have a tremendous impact that essentially contradicts current US government policy.
Put together, the newly increased portfolio investments in China—and the prospects of further increases—have a tremendous impact that essentially contradicts current US government policy
Despite broad bipartisan consensus about US efforts to constrain China's economy, estimates by several major investment banks, the IMF, and BlueStar Indexes (which I founded) suggest aggregate equity and bond portfolio investment into China could exceed $800 billion between now and the end of 2023. Those investments will significantly support the Chinese economy and currency even as China's current account balance has shifted to a deficit for the first time since 1993.
In other words, while China would otherwise face substantial pressure on its capital account, investment shifts that are virtually on autopilot from Americans and other global investors will materially contribute to relieving those pressures. Not only that but the efforts of the US government to impact the Chinese economy through tariffs and other policies will also be counteracted by these portfolio flows. Put simply, the international investment allocations now being implemented by American investors are directly opposed to current US trade and economic policy.
These portfolio shifts also pose significant investment risks. While investing in volatile emerging markets is inherently unpredictable, China is unique in not only its unprecedented allocation within international equity funds but also because of the serious concerns expressed by American policymakers about its political and economic system. The risks include the timing, coming as it does right as US foreign and commercial policy galvanizes to contain China; the possibility of interference from Beijing, given that most listed Chinese companies involve a degree of state control; the potential imposition of capital controls, where investors may be denied the ability to extract their investments; the impact of US sanctions on individual companies; and finally, the reputational risk from Chinese companies that have low ratings on the environment, on social factors, and governance.
Of course, all forms of investment entail risks. But it is imperative to ask whether average Americans should be investing in a country that is a major strategic competitor to the United States, let alone to such a degree that these growing allocations are occurring without a full or explicit understanding of their relative size and the composition within portfolios.
While China would otherwise face substantial pressure on its capital account, investment shifts that are virtually on autopilot from Americans and other global investors will materially contribute to relieving those pressures
This is not an argument against index funds, which strive to be objective and rigorous in their analysis, emphasizing investment-related issues to determine country categorizations between developed, emerging, and frontier markets. Nor is it an argument about broad diversification toward international markets. But institutional asset owners like pension funds—and especially individual investors—do not usually see the impact of major index changes. And the rapid inclusion of Chinese shares in emerging and international indexes is dramatically skewing the weights of countries and stocks with unprecedented impact.
US authorities may already be considering curbs on American investments in China, underscoring the importance of this issue. The Trump administration has been deliberating the imposition of limits on US pension funds' positions in China. Last August, Sens. Jeanne Shaheen and Marco Rubio urged the administrator of the federal Thrift Savings Plan (TSP), the largest retirement plan in the United States, to reverse its decision to include emerging markets—because of the exposure to Chinese equities—in its benchmark. Their concerns were followed in November with a bill that would conditionally ban the investment of TSP funds for military and federal government employees in securities listed on mainland Chinese exchanges.
In addition to TSP, the federally administrated Pension Benefit Guaranty Corp.'s portfolio includes a major emerging market allocation and has experienced the same increased exposure to Chinese equities this year, as will the portfolios of most state-administered public pension plans. BlueStar estimates that just the 30 largest US public pension plans have more than $150 billion in emerging market equities, of which more than $50 billion is now invested in Chinese companies.
Even as Congress and the White House consider potential legislation or directives, investors and fiduciaries should act too, and they have a straightforward two-step process ahead of them. First, to do their homework and look under the hood of their international equity portfolios to understand the growing weight of China and the existence of so-called bad actor companies as defined by the US government. Second, if directed by investors or their advisors, fund managers should screen out companies that are under US sanctions and those that do not adhere to American standards of accounting transparency. They could also consider adjusting the weight of China, based on their views on both portfolio risk and alignment of their values with their investments. While many of the policy proscriptions emanating from Washington highlight the growing concentration of China in portfolios and the resultant disconnect with US policy, it is essential to engage in the same intensity of scrutiny with all countries and companies.
The starting point for prospective solutions to this quandary is simply awareness of the scope of the problem. For institutional pension fund and endowment portfolios, this is the responsibility of their fiduciaries—the investment committees and boards that oversee these large pools of assets. Beneficiaries are also stakeholders, and they should make their voice heard, too. Next, fiduciaries should have a dialogue at the board and staff levels and eventually with their asset managers. As an outcome of this process, the goal should be to determine how much single-country risk is acceptable and, if the large and growing weight of China is identified as a key issue, to articulate an intention to address it.
One key element of a solution is to evolve or modify the choice of index benchmarks.
One key element of a solution is to evolve or modify the choice of index benchmarks
For the TSP, this could be as simple as backing away from its decision to shift from a developed market focus to one that includes emerging markets. For the hundreds of public pension plans and millions of individual investors who already have substantial—and growing—exposure to Chinese stocks, it is essential that they consider an approach to control risks by attenuating the country, sector, and single stock concentration of the portfolio. While it sounds complex, this can be relatively easy to achieve, as several index providers offer benchmarks that use alternative weighting approaches.
Even though the dominance of a single country—China—in emerging markets is unprecedented, this is not the first time that investors have felt the need to take steps to reduce the weight of a market or even remove a market from their portfolios. We need only look back to the 1980s, when institutional investors successfully solved two thorny issues.
The first example was purely an investment risk-related decision regarding the soaring values of Japanese stocks in the second half of the 1980s, which many considered unsustainable. Institutional investors, together with their asset managers, took steps to reduce the weight of Japan in their developed market index funds, essentially taking a bet to correct what was perceived to be a market that displayed bubblelike characteristics.
The second example from the 1980s was essentially a political stand against apartheid in South Africa that rippled through American public and corporate pension plans as well as foundations and endowments. Over the course of the late 1980s and early 1990s, divestment from South African stocks gained near-universal acceptance, so much so that most institutional investors removed it completely from their benchmark indexes.
Today, a range of solutions can be developed, including screens at either the country or company level. It is important to recognize that in the eyes of many investors, China is not the only home to so-called bad actor companies. For example, some banks in Qatar and Jordan have been accused of facilitating payments to terrorist organizations; Turkey's Halkbank was indicted last October by the US Justice Department for fraud and money laundering while helping Iran evade US sanctions; and several Russian banks have been sanctioned by the United States and the European Union for their involvement in trade with Iran and North Korea. Adjusting one's exposure to these companies can be accomplished through a relatively straightforward screening process by asset owners or index providers, using objective data from third-party providers.
Given how the evolution of global index benchmarks have created a major challenge for investors, a purely passive approach to the problem is not tenable. A decisive course of analysis and action is required. Fiduciaries and stakeholders must address the glaring concerns of both the investment risks of China's large and growing weight in most of their funds and the implications of a clash between their values and their portfolio holdings. Given the intense competition between the United States and China, it could be considered illogical—and in the eyes of some observers, even immoral—to be investing retirement assets into holdings that might run counter to US interests. While the portfolio construction issues might seem arcane, addressing them is increasingly essential both to manage risk and to ensure an alignment with investors' values.
Steven Schoenfeld, is the founder and chief investment officer of BlueStar Indexes, which manages a family of global indexes covering emerging markets, global technology, and Israeli equities.