Weighting China in a Well-Diversified Portfolio

What should China's real weight be in a well-diversified portfolio? It's an important question, and not an easy one to answer.

We have a survey in the next issue of the Journal of Indexes that asks a dozen leading thinkers if China is underweight in global indexes.

I'm not going to give away the answers—you'll have to wait for the January issue to come out. But I thought I'd take a shot at answering the question myself, because it's hugely important.

On the one hand, the obvious answer is yes, China is definitely underweight. China is the world's fourth-largest economy by GDP, accounting for 5.5% of the world's output. And yet, the country ranks only 14th by free-float market capitalization, and accounts for just 1% of global market cap. An investor who follows a free-float capitalization methodology puts more money in Holland than China. Does that make any sense? I'd say "no."

But looked at another way, maybe China's weight is right. Right now, the dominant challenger to the free-float weighting paradigm is fundamental weighting, which uses measures like earnings and dividends to weight stocks.

Do fundamental ETFs provide more exposure to China? I decided to compare four emerging markets ETFS to find out. I looked at two ETFs that use float-market capitalization:

• iShares MSCI Emerging Markets ETF (EEM)
• SPDRs S&P Emerging Markets ETF (GMM)

And two that use "fundamental" weighting:

• PowerShares FTSE RAFI Emerging Markets Portfolio (PXH)
• WisdomTree Emerging Markets High-Yielding Equity ETF (DEM)

Surprisingly, the weights in the market-cap ETFs were on par with the FTSE RAFI ETF (PXH), and substantially higher than the dividend-focused WisdomTree fund (DEM). (EEM and GMM differ because GMM does not consider Korea an emerging markets country).

click to enlarge

But what if we went back to that GDP focus? The figure below includes my own calculations of GDP share within emerging markets, based on World Bank data for 2006. I've included Korea in the tally.

By this measure, China is substantially underweight in all the indexes, while Brazil in particular gets too much attention.

Clearly, the nascent capital markets in China aren't presenting enough opportunity for investors to put their money to work. That's changing, and changing fast, but in the meantime, investors have a serious question to consider:

What's an appropriate weight for China? Free-float market cap? Fundamentals? GDP?

There's still no easy answer.

Written by Matthew Hougan

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[Vaun]

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