Exit the dragon: MSCI EM ex-China assets top $11 bn as pessimism grows

India stands to benefit most from increasing flows into index excluding China

Once considered an emerging market (EM) darling, China is now facing ostracism from the EM basket due to a prolonged spell of poor returns, an uncertain economic outlook, and geopolitical hostilities.

The assets of a popular EM-focused exchange-traded fund (ETF) excluding China (ex-China), issued by BlackRock (iShares EM ex-China), have exceeded $11 billion this month, marking a twenty-two-fold increase from less than $500 million three years ago.
 

Market watchers note that an increasing number of passive investors, particularly from the US and Europe, are reallocating their investments to ETFs that exclude China.
 

India stands to gain the most from this trend, given its highest weighting in the EM ex-China index. Companies from Mainland China hold the highest weighting in the regular Morgan Stanley Capital International (MSCI) EM Index at 22.07 per cent.
 

In the ex-China index, this weighting is redistributed to other countries, with India and Taiwan seeing an increase of more than 4.95 percentage points each, and South Korea’s by 4.16 points.

“Given the Chinese economy’s struggles and market pressures, we could see a further shift in positioning away from China towards other EMs,” said analyst Brian Freitas of Periscope Analytics, who publishes on Smartkarma.
 

“In 2021, we highlighted the potential for US and European investors to reallocate their equity investments to indices excluding China, driven primarily by forward returns and a hardening public and political stance towards China.”

With Chinese markets underperforming, the MSCI EM ex-China Index has consistently outperformed both the MSCI EM and MSCI Asia ex-Japan indices over the past three years.
 

Despite a recent 12 per cent bounce, the CSI 300 Index of Chinese shares remains down 10 per cent and 29 per cent over one-year and three-year periods, respectively.
 

Pratik Gupta, chief executive officer and co-head of Kotak Institutional Equities, expressed that the EM ex-China ETF represents an emerging asset class. He noted, “Due to China’s poor performance in recent years, investors in the MSCI EM ETF have lost out. Now, the dilemma arises: whether to entirely exclude China, which currently has valuations at a multi-year low, or to invest in relatively expensive markets."

Currently, the CSI 300 Index trades at a 12-month forward price-to-earnings (P/E) multiple of 11x. By comparison, the Indian market commands a P/E of 20x, and Taiwan 17.4x — the top two weights in the ex-China index.
 

However, some argue that the decision to exclude China goes beyond weak performance or relative valuations.

“With US elections looming, a hardline stance could force asset reallocation away from China,” said Freitas, suggesting that more US pension plans may choose or be compelled to divest from China and Hong Kong and allocate funds elsewhere.

According to Freitas, passive funds currently hold $121 billion worth of Chinese stocks via the EM and related indices.

“If 20 per cent of passive holders reallocate their holdings to the EM ex-China ETF, that would mean a $24.2 billion reallocation among other countries,” he said. In such a scenario, India and Taiwan could potentially receive $5 billion each, with South Korea receiving about $4 billion.
 

These changes will not occur overnight but will unfold over time and should be factored into the asset allocation process, Freitas added.