How to Trim China Exposure in Emerging Markets ETFs

This article was originally published on ETFTrends.com.

Traditional emerging markets indexes, such as the MSCI Emerging Markets Index, are cap-weighted, meaning the largest companies in these indexes command the largest weights and so on. Cap-weighted emerging markets indexes also expose investors to some geographic concentration risk, mainly by way of China.

For example, the Vanguard FTSE Emerging Markets ETF (NYSEArca: VWO), which tracks the FTSE Emerging Markets All Cap China A Inclusion Index, the iShares Core MSCI Emerging Markets ETF (NYSEArca: IEMG) and the iShares MSCI Emerging Markets ETF (NYSEArca: EEM) each allocate approximately a third of their respective weights to Chinese stocks.

Smart beta alternatives, such as the Schwab Fundamental Emerging Markets Large Company ETF (NYSEARCA: FNDE), can help investors reduce China exposure.

FNDE tracks the Russell Fundamental Emerging Markets large Company Index, which selects, ranks and weights components based on fundamental factors like adjusted sales, retained operating cash flow and dividends plus buybacks.

Use FNDE to Reduce China Exposure

It is unlikely that cap-weighted emerging markets benchmarks will reduce China exposure anytime soon.

“For the foreseeable future, it is likely that most broad, market-cap-weighted emerging-markets indexes will have sizable allocations to Chinese stocks,” said Morningstar in a recent note. “Just how much Chinese stocks' representation in these benchmarks expands (or, potentially contracts) depends on the future growth of the Chinese market and the degree to which China A-shares are included in these funds' bogies. Both have been moving in a direction that suggests emerging-markets stock indexes will continue to increase their concentration in China.”

Today, FNDE allocates around 20% of its weight to China, significantly lower than its aforementioned rivals. However, FNDE “employs no direct limit on country weightings, so geographic diversification could still be an issue in the future. Also, it weights holdings by fundamental measures rather than market cap, making it a value-oriented strategy,” according to Morningstar.

Emerging markets are enjoying improved fundamentals thanks to corporate earnings improving as economic growth rebounds and strengthening currencies against the U.S. dollar on the back of improved economic outlooks.

FNDE “features a heavy bias toward stocks from the energy and materials sectors--segments of the market that are heavily exposed to volatile commodity prices and don't always compensate investors for bearing that volatility,” said Morningstar.

For more on smart beta ETFs, visit our Smart Beta Channel.

Tom Lydon's clients own shares of VWO.