Each year, the investment consulting firm Callan publishes an illustration called the periodic table of investment returns. It illustrates the performance of key asset classes on a year-by-year basis. That information is widely available, but Callan’s periodic table is unique: Each asset class is color-coded. And they’re ranked from best to worst each year. This makes it easy to see not just the performance but the relative performance of investments each year.
The periodic table is valuable because it reveals that there is rarely a consistent pattern to relative returns from year to year. On more than one occasion, in fact, the best investment one year has turned out to be the worst the following year. That is precisely Callan’s point. All investments—stocks, bonds, international markets—are unpredictable, but each is unpredictable in its own way.
The lesson for investors: Because of that unpredictability—and because investment cycles can be long—a key ingredient for success is to settle on a sensible asset allocation, then stick with it for the long haul. Following that approach, I make changes to the lineup of investments I recommend only infrequently. But now is one of those times.
I have never felt entirely comfortable with emerging markets—countries like China, Russia, India and Brazil—because their political, economic and legal systems are less well developed than in the United States. That makes them inherently more risky. But their economies are typically faster growing than in the U.S., and that makes them attractive. To balance these considerations, I’ve always included emerging markets stocks in the portfolios I manage, but only at a modest level—usually 5% of the stock allocation.
For a long time, that seemed reasonable. Yes, China and Russia were run by autocrats. But those were just two of the countries in the main emerging markets indexes. Many other countries—such as India—are democracies. Thus, for a lot of years, I was comfortable with broadly-diversified emerging markets index funds that included Russia and China because they also included many other countries. Unfortunately, though, things have changed. Five factors are of most concern:
1. Index change. Back in 2019, I talked about a change to the most prominent emerging markets index—the one managed by MSCI. According to The Wall Street Journal, MSCI had come under “heavy pressure” from Chinese authorities to increase the number of Chinese stocks in its emerging markets index. MSCI ended up making that change.
For China, this was a boon. But for investors holding funds that tracked this index, the result was a sizable increase in exposure to Chinese stocks. Today, they dominate the MSCI index, with a roughly 30% allocation. This figure had been even higher—around 40%—a few years ago. It’s dropped only because the value of China’s market has fallen, for reasons explained below.
I should note that MSCI wasn’t alone. FTSE, another major index provider, and the one that Vanguard uses for its emerging markets fund, made a similar move. These changes were problematic for investors because the increased allocations to China meant a decrease in portfolio diversification.
2. Common prosperity initiative. Beginning in late-2020, China’s leadership—in a set of inexplicable moves—began punishing many of its own companies. First, it blocked a planned public offering by a company called Ant Group. This was widely viewed as a punitive measure against Jack Ma, Ant’s largest shareholder, because he had made comments critical of the government. Shortly thereafter, Ma disappeared from public view for several months.
From there, China’s leadership took aim at a variety of other companies and industries. They forced a set of tutoring firms to become non-profits. And the government levied a set of seemingly arbitrary fines against companies like Alibaba and Tencent, two of the largest companies not only in China but in the entire emerging markets index. This was under the umbrella of a renewed “common prosperity” initiative. Ironically, the result was to erase about $1 trillion of value from China’s stock market.
3. Cyberattacks. Justice Oliver Wendell Holmes once said, “The right to swing my fist ends where the other man’s nose begins.” From our perspective here in the U.S., I suppose it’s the Chinese government’s prerogative to make policies as it sees fit, even if they seem unjust, inexplicable and financially damaging. Unfortunately, though, Xi Jinping seems to be extending his campaign of bullying beyond China’s borders.
According to the U.S. government’s Cybersecurity and Infrastructure Security Agency (CISA), China’s government regularly perpetrates cyber attacks against the United States. Targets include both our government and private companies. In addition, according to CISA, “China is conducting operations worldwide to steal intellectual property and sensitive data from critical infrastructure organizations, including organizations involved in healthcare, pharmaceutical, and research sectors…”
4. Russia’s war in Ukraine. Most recently, the Chinese government’s response to Russia’s actions in Ukraine has been unsettling. At best, it’s been mealy-mouthed. Unlike every decent regime in the world, China has failed to condemn Russia and indeed has reaffirmed its relationship. This is a problem for a few reasons. First, it’s simply abhorrent to remain silent about the human rights abuses Russia has perpetrated. It calls into question China’s judgment and decency. And though that may not sound like a financial argument, I believe it is. If you’re investing in any entity that doesn’t subscribe to shared principles, it raises the risk level of that investment.
A further financial consideration: Since China regularly rattles its saber in the direction of Taiwan, there is the risk that it could experience a similar economic isolation if it were to become aggressive in the way that Russia has toward Ukraine. When the value of Russian stocks was zeroed out of the emerging markets indexes this spring, the financial impact for investors was minimal because it only accounted for 3% of the index—much less than China’s 30%. If China were to be excluded in the same way, the impact on major emerging markets funds would be quite significant.
5. Overall posture. I’ve focused so far on a set of specific concerns about China. Unfortunately, though, the problem is larger than that. Each year, the CIA publishes its Annual Threat Assessment. It’s telling that just four countries have dedicated sections in this report. One is China. The others are Iran, North Korea and Russia. That’s the company China keeps.
This is how the Threat Assessment summarizes the Chinese government’s posture today: “The Chinese Communist Party (CCP) will continue its whole-of-government efforts to spread China’s influence, undercut that of the United States, drive wedges between Washington and its allies and partners, and foster new international norms that favor the authoritarian Chinese system.”
To be sure, we can’t expect every other government in the world to follow in our democratic mold. But it’s important to make a distinction between countries that happen to be different and those that are actively trying to undermine the United States. On this score, according to the evidence, China is simply up to no good. Since it accounts for a hefty 30% of major emerging markets indexes, it’s time for a change.
I still believe emerging markets are an important element for investors’ portfolios, providing exposure to faster-growing economies. But I no longer recommend the standard capitalization-weighted index approach employed by MSCI and FTSE, on which Vanguard, iShares and others base their emerging markets funds. Instead, I will begin shifting portfolios out of these China-heavy funds and into alternatives.
First among these alternatives is a fund called the Freedom 100 Emerging Markets Index (ticker FRDM). Created by a native of China who knows firsthand the issues there, the FRDM fund has a unique makeup: It’s “freedom-weighted.” That is, countries are weighted in proportion to their adherence to democratic values and other important principles. For that reason, not surprisingly, China has a zero weight in this index. And Russia, before it became uninvestable, also had a zero weight. This fund isn’t perfect. Its expense ratio is higher than a traditional index fund, and its holdings are a little top-heavy. Still, I view it as a fundamentally better investment because it doesn’t include China.
Because many investors share these same concerns about China, I expect to see more new funds introduced that offer emerging markets exposure without the China risk. FRDM is first on my list, though, because I agree with the premise that demonstrably undemocratic regimes carry higher risk. Russia has proven this. Also, FRDM recently achieved a three-year track record, which is a commonly-accepted threshold for investing in a new fund.