Seeking Alpha

EEM's China Syndrome

About: iShares MSCI Emerging Markets ETF (EEM)
by: David Pinsen

A recent Twitter thread highlighted the heavy China exposure of EEM.

Given the recent turn for the worse in the U.S.-China relationship, I present a couple of ways EEM shareholders who want to stay long can limit their risk.

I close by noting that I am currently neutral on EEM but that we appear to be in uncharted waters with respect to U.S.-China relations, so caution is warranted.

Alibaba (NYSE:BABA) is the 2nd largest holding in EEM. Image via Retail Detail.

The Looming China Risk In Emerging Market Funds

Seeking Alpha's Editor-in-Chief, George Moriarty, alerted me to a Twitter thread on Tuesday that should be of interest to holders of the iShares Emerging Markets ETF (NYSEARCA:EEM). I recommend scrolling through the entire thread below, but I want to highlight a couple of the tweets here, and then look at a couple of ways EEM shareholders who want to stay long can limit their risk.

One point the author of this Twitter thread, who goes by the handle "Scheplick", makes is how heavily exposed EEM is to China:

Scheplick suggests that this is risky in part due to the shift in American attitudes toward China's government with respect to its handling of human rights and other issues. As Open Markets Institute fellow Matthew Stoller pointed out on Tuesday, this has been quite a rapid shift.

(Regular readers may recall that I shared Matt Stoller's concerns about Boeing (NYSE:BA) in a recent article). Another point Scheplick makes is that these Chinese stocks traded in the U.S. are actually variable interest entities.

There's nothing new about this particular issue; I wrote about it a couple of years ago when Jim Chanos included it in his short case for Alibaba:

This isn't a flaw in the sense that it's wrong, but in the sense that it doesn't seem terribly relevant. We're referring to this comment by Chanos on China's VIE, or variable interest entity structure (via a March interview with Capitalize For Kids; PDF here):

[I]t's amazing to me every time we've actually gone from the macro in China to the micro, it looks worse. Low returns on capital, odd accounting, flows that you can't track, byzantine corporate structures, not the least of which is the VIE structure where Western investors don't even own the assets. Shareholders just own a piece of paper with a promise and as these Chinese companies get more and more leveraged, the debt is on the entity that has the VIE.

So, God forbid anything happens, you get nothing.

Our problem with this, upon reflection, is that it's largely true of any stock: common equity is the low man on the totem pole; if you own shares in an American company that goes bankrupt, you'll most likely get nothing in that scenario too.

I'm still not especially troubled by the VIE structure, but I think other points Scheplick raises merit concern. Let's look at a couple of ways you can limit your risk if you want to stay long EEM.

Limiting Your Risk In EEM

For both of these examples, I am assuming you own 1,000 shares of EEM and can tolerate a decline of 20% over the time frame of the hedges, but not one larger than that. I've circled the dollar cost of the hedges in both examples.

Uncapped upside, Positive cost

As of Tuesday's close, these were the optimal, or least expensive, puts to hedge 1,000 shares of EEM against a greater-than-23% decline by next June.

Optimal hedge on EEM via Portfolio Armor. Screen capture via the Portfolio Armor iPhone app.

The cost of this protection was $750, or 1.86% of position value, calculated conservatively, using the ask price of the puts (in practice, you can often buy and sell options at some price between the bid and ask).

Capped Upside, Negative Cost

If you were willing to cap your possible upside at 10% over the time frame of the hedge, this was the optimal collar to protect against the same, >23% decline by June.

Optimal hedge on EEM via Portfolio Armor. Optimal hedge on EEM via Portfolio Armor. Optimal hedge on EEM via Portfolio Armor.

Screen capture via the Portfolio Armor iPhone app.

Here, the cost was negative, meaning you would have collected a net credit of $70, or 0.17% of position value, assuming you placed both trades at the worst ends of their respective spreads.

Wrapping Up

I've given EEM a neutral rating here, as my site's analysis of options market sentiment about it doesn't suggest a steep decline is imminent. But longs may want to consider hedging in the event my site's analysis is wrong. The shift in sentiment toward China over the past week, after the incidents with the NBA and Activision Blizzard (NASDAQ:ATVI), has been striking, as Bloomberg's Matt Miller notes below.

This feels like uncharted territory for the U.S.-China relationship.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.