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June 30, 2017
Like the Dow Jones Industrial Average or the S&P 500 Index for American stocks, the MSCI Emerging Markets Index (EM) is the leading stock market benchmark for less developed countries. The EM – like all widely followed stock market indexes – was originally designed to measure the general level of stock prices. Without an index we could not answer the question: How did the stock market do today? Over time the EM morphed from an information tool into an investment product. Exchange Traded Funds (ETF) linked to the MSCI Emerging Markets Index now manage $624 billion. In mid-June MSCI, Inc. announced it will expand China’s presence in the EM over the next several years, highlighting a potential conflict between the EM as a stock market barometer versus an investment product.
To properly gauge broad market movements, indexes are weighted by market value rather than investment risk. Larger companies and countries comprise larger percentages of an index (we explored this topic in our newsletter, The S&P 500 Index: A Limited View of the Economy, available on our website www.ghpia.com). For example, Apple Inc. with a total market value of $746 billion is the largest company on the S&P 500 Index with a 3.6% weighting, while the 50th company Union Pacific with a market value of $88 billion, comprises just 0.4% of the index. The 500th company in the S&P 500 Index is Autonation Inc. (market value $4 billion) with a mere 0.01% weighting. Similarly, China’s current EM weight is 28%, while the next highest weighting is India at 9%.
Chinese stocks fall into three basic categories. “H Shares” are mainland Chinese companies listed on the Hong Kong Stock Exchange. “B Shares” are mainland stocks listed in Shanghai or Shenzen but accessible by foreign investors. “A Shares” are by far the largest segment of the Chinese market but are mostly limited to Chinese investors. Although A Shares are currently excluded, China is nonetheless the largest country weighting on the EM index with only H and B shares represented. As MSCI gradually incorporates A Shares into the EM over the next several years, China’s weighting could exceed 40% based on current market values.
China is the biggest EM country, but is it the best for investors? Of the 24 countries on the EM, quite a few are wealthier on a per capita basis with superior rule of law. The World Bank ranks China 123rd in the world for protecting minority investors, down 5 places from 2016. Public company shareholders have very few legal rights, corporate governance and financial transparency are poor, and company officers and directors face very little legal liability.
There are numerous examples of Chinese companies falsifying financial and nonfinancial reports to their shareholders, company officers using corporate assets for personal gain, self-dealing, sweetheart loans to family and connections, interference from politically connected individuals, forced lending to other state-owned companies, uncertain title over corporate assets and other value-destroying transactions for minority shareholders. Chinese law does a poor job protecting shareholders from predations such as these.
Other countries in the EM are smaller than China but do a better job protecting investors. Legal institutions that protect property rights, enforce contracts and protect creditors are far superior in many other EM countries such as Taiwan, South Korea, Poland, Chile, the Czech Republic, Hungary, South Africa and Malaysia. Although Poland’s population is smaller than China’s, its GDP per capita is twice as high, and it ranks 42nd in the world for protecting investors. Even politically chaotic Brazil is wealthier on a per capita basis than China and ranks 37th in the world for protecting investors.
Developed countries such as Germany, France or the United Kingdom are wealthy, industrialized democracies with strong legal and political institutions. Foreign and domestic investors are typically respected equally under the law. Emerging market countries, however, vary tremendously. Some are more industrialized and some less. Corporate governance is better in some places than in others. Some are democracies and some authoritarian. Most are plagued with varying degrees of inefficient or corrupt legal and political institutions. Thus, country selection is key when investing in emerging markets.
Investing in index funds can be problematic when market value is the key allocation principle rather than investment risk. As a foreign stock market barometer, incorporating Chinese “A Shares” in the MSCI Emerging Market Index is certainly appropriate. As an investment fund, however, a 40% or greater exposure to China could pose unwarranted risks. Given the immense economic, political, financial and legal dispersion among emerging market countries, MSCI could be leading investors astray.
Investment Insight is published as a service to our clients and other interested parties. This material is not intended to be relied upon as a forecast, research, investment, accounting, legal or tax advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The views and strategies described may not be suitable for all investors. References to specific securities, asset classes and financial markets are for illustrative purposes only. Past performance is no guarantee of future results.
