- Last fall I wrote an article about an ETF that excluded China due to its large weight in most Emerging Market funds.
- With the current virus shutting down Chinese production, I would have thought EMXC would outperform EEM. NOT!
- This article tries to figure out why EMXC has under performed EEM in 2020.
When MSCI decided to continue increasing China’s weight in their Emerging Markets index, now over 33%, I found an ETF that would allow investors wanting to avoid China to do so, NASDAQ:EMXC. The COVID-19 virus was first reported at the end of 2019 and is spreading worldwide. With China being the world’s 2nd largest economy and #1 exporter, logic would seem to indicate any ETF exposed to Chinese companies would trail similar ETFs without that exposure since the start of 2020. For the two MSCI indexed EM funds, that has not been true. EEM was down 9.69% while EMXC dropped 12.57% in the first two month of 2020. This article is my attempt to read the tea leaves to understand why.
Comparing EMXC and EEM
Ishares provides several EM ETFs based on various MSCI Indices. MSCI Emerging Markets (NYSEARCA:EEM), with $29b in assets, and a newer one with only $35mm in assets, the MSCI Emerging Markets Ex China (EMXC), which I will use in this article.
Since EMXC has no China exposure, the other country weights and performance for the first two months on 2020 was the first clue I examined.
|Country||EMXC Weight||EEM Weight||Weight Difference||EM ETF Available||2-MO Return|
|United Arab Emirates||0.95%||0.60%||0.35%||UAE||-9.31%|
Source: PortfolioVisualizer; compiled by Author
Many ETFs classify a company by their country of incorporation, thus you will see countries listed that are clearly not EM in nature. For the true EM countries, I tried finding a fund for that country so I could see how they performed. While most are based on a MSCI index, not all are, which does 'dirty' the results somewhat. Below is also from PortfolioVisualizer, and it graphically shows why EMXC underperformed EEM in early 2020.
China (MCHI) was the best performing country. The question then becomes, why? Growing up, I remember the phrase, "When the USA sneezes, the World catches a cold". With China now so embedded in many supply chains, that seems to be the consensus about China now. China now accounts for a third of global trade—about 10 times more than during the SARS epidemic. With many EM countries dependent on the export of minerals and agricultural products, I next looked at that data to backup my trade premise.
China is the major trading partner of many countries. The following tables are based on 2016 data as shown on the CIA World Factbook.
Source: Trading Partners
If you look at the full list on the linked source, many more of the countries represented in both ETFs have over 10% or 20% of their imports or exports coming from China. If those imports are interrupted, importing economies will be hurt. On the flip side, China is also a large importer from many EM countries. China's oversized importance to EM country's trade helps explain why they have felt the pain more. Add to that most 3rd-World countries economies are not as well diversified as the US, Japan, and Europe, any disruption will have a greater impact on their GNP.
Source: China Commodity imports
China is the world's second largest importer. In 2017, it imported $1.7 trillion. The United States, the world's largest, imported $2.3 trillion. With much of the country in lockdown, the virus could affect up to 42 percent of China's economy, according to Standard Chartered. China imports raw commodities from Latin America and Africa. These include oil and other fuels, metal ores, plastics, and organic chemicals. It's the world's largest importer of aluminum and copper. China’s commodity consumption has fueled a world-wide boom in mining and agriculture, but that can hurt just as much as countries dependent on these products when China stops buying.
Commodity price declines (Commodity prices) helps explain the performance divergence too. China, being a large commodity importer, benefits from declining commodity prices whereas many EM countries are hurt by declining prices being major exporters and having commodity-dependent economies.
Many EM countries are also middleman in the world supply chain. Their economies are being hit by imports from China no longer being available; part of the ripple effect of companies becoming too dependent on a single source for even simple components of their final product.
With much of China in lock-down mode, that also means 1.5 billion consumers are not buying as much as before. While this effects US companies more than EM-based companies, the fear factor enters the equation. For EM companies, their Chinese workers could be blocked from going to work thus cutting demand for their exports.
There are some strategies one can implement to reduce portfolio risk to the effects of COVID-19.
- Reduce Commodity Exposure: The most profound effects of a slowdown in China’s economy would be reduced consumption of commodities, and as a result, lower commodity prices over the long-term.
- Reduce Entertainment Exposure: While many companies can make up for lost production, companies such as airlines, hotels, or cruises cannot.
Increase Diversification: Investors can mitigate the effects of a decline in any individual country by ensuring that their portfolio is diversified in countries around the world.
- Hedge: Use Inverse ETFs or ones that specialize in shorting stocks to provide some downside protection. You can also buy Put options on companies at the greatest risk of being effected by COVID-19 economic impact. Most hedging choices do not come cheap and timing such bets is critical.
As for investing in EM companies, one could do more research to determine which countries are less effected and invest there if a Country-level ETF exists. Or wait for the virus to be contained and buy either EMXC or EEM. Another approach would be to use a combination of EMXC and MCHI that would allow the investor to control their Chinese exposure as a percent of the EM exposure. EM countries should do well post-virus as they are projected to grow faster than Developed countries. Some of those statistics are in original article on EMXC: EMXC article.
All that said, this quote from Reuters is important to remember:
Even if the coronavirus was to magically disappear tomorrow, the downstream effects to the disruption to global commerce and supply lines will be felt for some months to come.
Franklin-Templeton is a highly respected EM investor. They recently posted this article on EM & COVID-19 on SeekingAlpha: F-T Analysis.
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This article was written by
I have both a BS and MBA in Finance. I have been individual investor since the early 1980s and have a seven-figure portfolio. I was a data analyst for a pension manager for thirty years until I retired July of 2019. My initial articles related to my experience in prepping for and being in retirement. Now I will comment on our holdings in our various accounts. Most holdings are in CEFs, ETFs, some BDCs and a few REITs. I write Put options for income generation. Contributing author for Hoya Capital Income Builder.
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