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Veer Away From China With These Emerging-Markets Products

Veer Away From China With These Emerging-Markets Products

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Is your emerging-markets fund gorging on China? Joining me to discuss that topic is Dan Sotiroff. He is an analyst in Morningstar's Manager Research Group.

Dan, thank you so much for being here.

Dan Sotiroff: Hi, Christine. Thanks for having me.

Benz: There has been a lot written about this issue of concentration in Chinese securities in emerging-markets portfolios, and we are going to talk about that and talk about some funds that have workarounds or have portfolios that aren't as heavily skewed toward China. But before we get into that, let's talk about total market international funds. How heavily exposed are they to a single region, China?

Sotiroff: This is really kind of an important point to stress. If you look at a total foreign market fund, emerging markets make up about 15% to 20% of that universe. They are relatively small portion of the total international space. China in particular, makes up maybe about 7%, 8% of that mix. It's not really a huge problem if you are already in a total international fund or if you have a portfolio, let's say, where you have a developed markets fund and an emerging-markets fund. This problem of country concentration is really, really focused on just the emerging-markets universe.

Benz: Let's look specifically at broad emerging-markets ETFs that simply weight markets by market capitalization. First, let's talk about why they are so heavily exposed to China and then let's talk about what their concentrations look like.

Sotiroff: If you look at what's really happened over the past decade, the Chinese stock market has been one of the stronger-performing ones in the emerging-markets universe. That's one of the reasons why China is so heavily weighted in a lot of these. The other reason, I think it's smaller but it's still important, is you have had the introduction of A shares. FTSE did it a few years and now MSCI has brought them on this year.

Benz: These are Chinese A shares?

Sotiroff: Right. The locally-listed A shares. Those two factors have really been driving this larger allocation to China in a lot of these funds. Right now, depending on the index you are tracking, it's anywhere between about 30% to 35%. The MSCI indexes are around 30%, 31% and the FTSE indexes are around 35%. Either way you look at it, it's a pretty big chunk of the emerging markets universe. I think most people would agree to that.

Benz: Right. If you are buying one of these broad total emerging-markets products, you better like China because you are getting a lot from it.

Sotiroff: Right. We've seen this problem before in other international indexes. If you look at the EAFE index going back to the early '90s, it was heavy in Japan, and that's kind of weighed on it over the past few decades. It's not as bad as that situation, but it certainly is kind of a cause for a concern.

Benz: You and the team who focus on passive strategies, you have looked at some of the emerging-markets products that for various reasons have less exposure to China. Let's talk about that. These are so-called strategic beta or factor emerging-markets funds. How do they arrive at less exposure to China?

Sotiroff: Some of them are kind of coincidental but some of them are controlled. For starters, we'll look at the Schwab Fundamental Emerging Markets ETF. Really, what that is, that's a fundamentally-weighted index of large companies listed in emerging markets. Being that it's a fundamental index, this is really more of a value fund that has about 20% exposure to China. While that's favorable, the one thing I would point out is, this is a value fund. You are taking on other forms of risk within that fund. You have a higher exposure to commodities-based companies, primarily oil and energy companies, and then a little more in the materials sector as well. While it's good that you are dialing back on China, you are taking on some other risks there as well.

Benz: It makes you more economically sensitive one would think?

Sotiroff: Exactly. They are much more sensitive companies to the commodities cycle. We have that fund at Neutral right now for that type of reason. Another fund I'd point out that I think we are much more favorable of is the iShares Edge Min Vol Emerging Markets ETF.

Benz: So, that's a low volatility product?

Sotiroff: Correct. What that fund is really doing is it's looking for less sensitive companies. you are a little overweight in the consumer staples and the utilities sectors as you would expect. That fund at the end of the day washes out, you are about 25% in China with that fund. A little bit better compared to like a cap-weighted index. But the bigger thing is, is you are taking on a lot less market risk with that as well. We've got that at Silver for that reason. The expense ratio is also pretty good at 25 basis points.

Benz: The value to this fund is not just that it has controlled exposure to China, but it also reduces risks overall in the portfolio?

Sotiroff: We think it's going to be more stable going forward. So far, its track record has shown an ability to do that. We are pretty positive on that.

Benz: It might be a little easier to own. DFA also has a product that has reined in its China exposure. Let's talk about how Dimensional approaches constructing its emerging-markets product.

Sotiroff: They are a contrast compared to the other two. Whereas the weights in China of the previous two funds were kind of coincidental, those funds don't really control their exposure to China. DFA goes a different route and directly controls its country exposure. right now, China is about 17.5%, that's what DFA targets explicitly. That's not just for China, that's for any country. It's at 17.5% right now, but the other big benefits with the DFA fund like that is it's just super diversified. Thousands of different stocks, it generally represents the universe very well. You don't see any sector or industry biases like we saw in the other two.

Benz: This one is Silver-rated, too. I guess one caveat though with DFA is I can't just call up DFA and say I want to buy this fund. You need to work through an advisor who uses DFA.

Sotiroff: Right. That's the big problem with this one is, it's such a good fund but you really got to be working with an advisor or an approved intermediary to get access to it. Some 401(k) plans might have it. It's something to watch out for. But yeah, that's always the sticking point with DFA strategies.

Benz: Dan, really interesting topic. Thank you so much for being here to discuss it with us today.

Sotiroff: You're welcome. Thank you.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.

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