More China with your emerging markets?

The decision on whether to invest with an active manager who might avoid China shares, or a passive tracker fund that will look distinctly China flavoured in the future, has never been more important.

If MSCI says yes to domestic Chinese shares, their incorporation in its broad emerging markets index could begin as early as May next year. Chinese shares currently account for 23.6 per cent of the MSCI Emerging Markets Index and any investor purchasing the lowest-cost emerging markets exchange traded fund (ETF), iShares Core MSCI Emerging Markets IMI UCITS ETF (EIMI), has a 23.3 per cent exposure to China.

But if China A shares are brought into the index this country could account for as much as 43.6 per cent of the index in future, based on figures released in 2014 when the consultation on whether to do this began. MSCI proposes a gradual incorporation of Chinese A shares into this index, and would start by including 5 per cent of A share companies and incrementally move up to 100 per cent. Eventually, China A shares would account for 20 per cent of the MSCI Emerging Markets Index, sending billions of pounds invested in passive funds into A shares.

Offshore Chinese shares are already included in the MSCI Emerging Markets Index but until now onshore A shares, which are highly restricted by quotas for foreign ownership, have been kept out. These stocks have been the subject of much controversy and MSCI decided not to include them last year on the basis that China's capital markets were not accessible or open enough.

A shares soared in popularity following the launch of the Hong Kong Shanghai Stock Connect programme in 2014, which allowed investors in either market to trade both onshore and offshore shares, but crashed back to earth last year. In 2015, the CSI 300 index, which tracks the performance of 300 stocks traded on the Shanghai and Shenzhen stock markets, soared by more than 60 per cent, while the MSCI Emerging Markets index fell 4.41 per cent. However, so far this year the CSI 300 Index is down 17 per cent, while MSCI Emerging Markets index is largely flat, having risen only 0.03 per cent.

The addition of China A shares to the MSCI Emerging Markets Index would fundamentally change the nature of passive emerging markets investing, and commentators are divided over the impact.

Peter Sleep, senior portfolio manager at Seven Investment Management, says: "I think the inclusion of China A shares would be the biggest thing to hit passive investing since the Berlin Wall came down.

"Including China A shares may add to emerging markets volatility, in that it will increase the specific risk coming from mainland China, but the other side of the coin is that it will reduce the risk coming from commodities, and possibly financials, which dominate the MSCI Emerging Market Index at present.

"On balance, I think it is a good thing for emerging markets investors as it will give them a greater set of companies to choose from, and these companies will dilute the influence of big companies such as Gazprom (Rus:GAZP) and Vale (Braz:VALE3s)."

Paul Jackson, head of research at exchange traded fund (ETF) provider Source, also thinks China inclusion is an opportunity rather than a threat for emerging markets investors, and would make the index both more diverse and representative. "Whether China A shares are accepted this year or next year, they seem to have ticked all the boxes MSCI required, so it's pretty much a done deal," he says. "It is now just a question of timing."

"The addition will make the emerging markets index more representative of those emerging markets economies. Not having China in there is like taking the US out of MSCI World Index. I would consider MSCI Emerging Markets more diversified if it included A shares."

But Adam Laird, passive investment manager at Hargreaves Lansdown, says: "It wouldn't surprise me if MSCI provided alternative emerging markets index options, so that not everyone would have to move a load of money into A shares all at once."

What you get with an active manager

Active managers would also be affected by the move, but could choose to buy at a lower level if they felt cautious on the market, which many do.

Darius McDermott, managing director at Chelsea Financial Services, says: "We wouldn't expect an emerging markets manager to go wading into China at index level [if A shares are added to the index], and it's a really good reason to be wary of passive emerging markets and China investing as well."

Jason Hollands, managing director at Tilney Bestinvest, says: "I definitely don't think you want to passively track an emerging markets index. We're really nervous about China and prefer India, relatively speaking. I would choose an active manager with a cautious approach to these markets who was prepared to take very bold views on where they should allocate."

He likes active funds that lean towards India, which he says benefits from being a net importer of energy, and has favourable demographics and a pro-reformist government led by prime minister Narendra Modi. As a result, he likes JPMorgan Emerging Markets Investment Trust (JMG). "This trust has a big weighting to India and is very underweight China," he says.

Over 10 years JPMorgan Emerging Markets has beaten MSCI Emerging Markets Index, returning 99.4 per cent against 68.7 per cent for the index. The trust has also held up well when the index has plummeted: for example, over one year MSCI Emerging Markets is down by more than 17 per cent while the trust is down 8.6 per cent.

JPMorgan Emerging Markets is 23 per cent invested in India and just 7 per cent invested in China. MSCI Emerging Markets has a 23.6 per cent weighting to China and an 8.1 per cent weighting to India. Recently the trust has benefited from overweight positions in Brazil and South Africa, which have bounced back on rising commodity prices. But its managers argue that exposure to stocks with good fundamentals put them in a good position for long-term capital growth. The portfolio is heavily weighted towards financials and technology companies.

Mr Hollands also likes Fidelity Emerging Markets (GB00B9SMK778)*, an open-ended fund that has large holdings in US-listed NetEase (US:NTES) and Baidu (US:BIDU), but is heavily skewed towards India and South Africa. The fund has 36 per cent of its assets in emerging Asia and almost 20 per cent in Africa. Its manager, Nick Price, puts an emphasis on scrutinising company balance sheets when selecting shares. Over five years it has beaten MSCI Emerging Markets Index by some margin, making 12.2 per cent while the index lost 11.6 per cent.

Mr McDermott says that income-focused actively managed emerging markets funds also enable investors to reduce risk. "You are buying companies that are mature enough to pay dividends, which one assumes have better corporate governance, and you have income as a part of your return to give you some protection," he says.

He likes Charlemagne Magna Emerging Markets Income (IE00B8QB4001), a less well-known emerging markets fund focused on dividends. However, its performance has not been as strong as the Fidelity or JPMorgan funds, implying that in this case dividends have not protected investors. Despite solid returns in 2012 and 2013, heavy losses in 2011 and 2015 have meant it continues to underperform the index.

An active fund deliberately moving away from its benchmark and from China is the beleaguered Templeton Emerging Markets Investment Trust (TEM). Manager Carlos Hardenberg took over the trust in October 2015 from emerging markets veteran Mark Mobius, and is trying to end the fund's underperformance against its index by looking for under-the-radar stocks and regions set to outperform.

Mr Hardenberg says China is "a big dark shadow. You have a banking system that is looked at with a lot of scepticism for the right reasons. It is not prudent to believe that these numbers are right - they are still showing non-performing loans below 2 per cent and that cannot be true.

"We have moved away from the very large blue-chip emerging market companies - those could be in the commodities space, or very large conglomerates and companies with government affiliations - and we are looking intensively for opportunities in the mid-cap segment," he says.

The trust has more than 20 per cent cent invested in Hong Kong and China, and selective exposure to A shares, but Mr Hardenberg is nervous about the way in which inclusion of China A shares in MSCI Emerging Markets Index would "distort the index".

Instead, he is looking for "companies within emerging markets that excite us in terms of their ability to develop sustainable technological advantage, thereby creating barriers to entry, a competitive advantage and a strong relationship with clients".

He adds: "It's very easy to find an iron ore producer in Brazil or mine operator in South Africa, but to find these [disruptive] companies you have to do far more digging."

Recent additions include companies such as Largan Precision (3008:TAI), a Taiwanese company that makes camera lenses for smartphones, and companies that provide exposure to countries such as Peru, Kenya and Cambodia.

Utilico Emerging Markets (UEM)* is another benchmark-eschewing investment trust that has held up well amid volatility. It currently trades on a discount to net asset value (NAV) of about 10 per cent, wider than its 12-month average discount of 8 per cent, despite the fact it has consistently beaten its benchmark. Over 10 years it has returned over 113 per cent, and over one year has fallen only 7.3 per cent against MSCI Emerging Market Index's fall of 17.2 per cent.

Utilico Emerging Markets focuses on sectors and companies displaying the characteristics of essential services or monopolies, such as transport infrastructure and utilities, and its manager looks for companies with strong balance sheets. Unlike the MSCI Emerging Markets Index, it now has a large investment in Romania and has heavily reduced its exposure to Brazil from around 37 per cent five years ago to just over 11 per cent today.

The trust does have a substantial chunk of its assets invested in China - 26.3 per cent - but has proved adept at avoiding the most volatile areas of emerging markets, adding value over index trackers.

*IC Top 100 Fund

Performance of funds, trusts and indices (% total return)

Source: FE Analytics, as at 24.05.16

Cumulative total returns (%)

Source: FE Analytics, as at 24.05.16

iShares Core MSCI Emerging Markets IMI UCITS ETF country weightings

Source: iShares, as at 30.04.16

JPMorgan Emerging Markets Investment Trust country weights