Traditional international index funds assign a weight to each country based on the size of its stock market. But in the case of China, that’s a bit misleading. Despite having the world’s second-largest economy, China has a relatively small number of publicly traded companies. Moreover, many of those publicly traded companies have been off-limits to foreign investors. As a result, the Vanguard Total World Stock ETF (VT) allocates just 2.5% to China—considerably less that than the share allotted to much smaller economies such as Canada, Switzerland and France.
This is about to change: during the coming months and years, index investors will be able to access more of China’s vast economy. Vanguard recently announced that its flagship emerging markets ETF, the Vanguard FTSE Emerging Markets (VWO), will soon be adding China A-shares to its benchmark index. This development will also affect Canadian-listed ETFs that include this fund as an underlying holding.
Taking the A-train
Let’s look at what this means for indexers. Right now, most foreign investors can buy public companies in mainland China only through share classes denominated in foreign currency and traded on exchanges outside the country, particularly in Hong Kong and the US. These are the shares included in the emerging markets funds that North Americans own today.
A-shares, by contrast, are denominated in renminbi and are listed on China’s national stock exchanges in Shanghai and Shenzhen. They are generally available only to Chinese nationals and a small number of highly regulated foreign institutional investors.
But this regime is changing as China begins to loosen its control over foreign investment. That has prompted index providers to consider adding A-shares to their popular emerging markets indexes. FTSE (the index provider for many Vanguard funds) has already done so, and MSCI (whose indexes are tracked by iShares and BMO funds) seems likely to do so this year. As the index changes unfold, ETFs tracking these benchmarks will be compelled to add Chinese A-shares as well.
The upshot is that China will get an increasingly large share of cap-weighted indexes. It won’t happen overnight: Morningstar estimates the changes will bump up China’s allocation in the FTSE Emerging Markets Index by a modest three percentage points in the near term, from about 29% to 32%. But over time it seems likely that proportion will grow considerably as additional A-shares become available to foreign investors.
This evolution will affect the Canadian-listed Vanguard FTSE Emerging Markets (VEE), since this fund uses VWO as its underlying holding. It will also have a modest effect on the Vanguard FTSE All-World ex Canada (VXC), which gets its emerging markets exposure from VWO. It seems likely that emerging markets index funds from other providers will also see similar changes in the future, including the iShares MSCI Emerging Markets (XEM) and BMO MSCI Emerging Markets (ZEM), which both track the same benchmark.
What’s it all mean?
So what’s the takeaway message for Couch Potato investors who have some emerging markets in their portfolios? At this point, it’s hard to know what effect the addition of Chinese A-shares will have, but it’s likely to be very small. It should not prompt you to make any changes in your portfolio. Let’s remember that the allocation to Chinese A-shares in a balanced portfolio will be trivially small—Vanguard estimates they will make up 0.55% of VXC, which itself is less than half of a balanced ETF portfolio.
Taking a longer view, passive investors should generally applaud any index changes that better represent the global markets. As Forbes puts it, including China’s A-shares in widely used emerging markets indexes is “acknowledging that the Chinese mainland stock market has matured and is ready for serious, long term investors.”
It’s interesting to see how simple portfolios can adapt to changes in the world. Especially since the investor doesn’t need to actively participate or keep himself up to date.
You say that index changes that better represent the global markets should be applauded.
You also recommend a Canadian allocation in your model portfolios much higher than Canada’s share of the global markets.
I know you’ve answered this question before, but I’ll ask it again. Why shouldn’t we strive to replicate global markets in our own portfolios as Canadian investors?
What will be the impact of ETFs that track these indexes have on the share prices when they begin buying A-Shares? Will this added demand not temporarily bid up share prices? There will also be an exchange risk it seems, unless the ETF is hedging. Just asking….
@ChumBum: As you acknowledge, I have answered this question before and it comes down to a combination of currency risk, costs, taxes and behavioral issues. Investors are free to disagree and hold 4% of their equity portfolios in Canada if they prefer.
@Don: Increased currency risk is not really an issue, as emerging markets index funds are already fully exposed to foreign currencies (none of them use hedging). Will there be some market impact as index funds buy up these shares? Perhaps, but that’s the reason the changes are being rolled out gradually. I would expect any effect to be exceedingly small.
@CCP: For those holding Emerging Markets by the piecemeal approach, is there any development along the lines of funds holding a larger percentage of foreign stock directly, rather than through ownership of EM shares through the US parent company (as in the situation of ZEA intending to eventually hold all stock directly)?
In my taxable account I hold XEC, which appears to own everything through the US iShares stock, as does the VEE appear to own everything through the US Vanguard parent. Just eye-balling the ZEM web-page, it looks like about 25% is owned through the US subsidiary, but the rest is owned directly, it seems. Is this worth converting all my XEC to ZEM, even in the absence of any indication of the eventual intent of B of M?
@oldie: Unlike iShares and Vanguard, BMO has no US parent company, so they have more incentive to hold stocks directly. While there is an advantage to direct-held stocks in terms of withholding taxes, there is also a tradeoff: holding emerging markets stocks through a US-listed ETF offers economies of scale that a Canadian ETF can never hope to match. This can mean replicating the index more completely, lower transactions costs and other benefits that can reduce tracking error.
With respect to China A-shares specifically, only a limited number are being made available to foreign investors. Vanguard has secured an allotment, but I am not sure how easy this will be for the other ETF providers.
@CCP – I assume the MSCI EAFE index will add more China as well, do you have any info? I couldn’t find anything on their site, is it also going up in allocation to your knowledge?
Just interested as I’m using the e-series, international index e-series claims to follow that index.
On a separate issue, I notice that they seem to be holding the iShares MSCI EAFE for 2.1% of value, largest single holding – is this a new strategy for them to divest the individual holdings and hold an ETF, or is there an issue getting some stocks directly or some similar issue?
Thanks for the work on this great resource.
@Craig M: Thanks for the comment. The MSCI EAFE includes only developed countries, so China is excluded: the changes affect only emerging markets indexes.
Sometimes index funds use ETFs for part of their underlying holdings simply to benefit from the economies of scale. For example, if you need to invest a small amount of money it’s much cheaper to buy an ETF than to buy the underlying stocks. It also helps when the ETF needs to make redemptions to investors who sell their units in the fund.
That’s a great news as I am open for extra manageable risks for greater rewards. China is a lucrative market for sure when looking at a longer term.
Not that we should be timing the market etc. etc., but out of curiosity are the Chinese A-shares the ones that tanked like crazy this week?
@Sean: Yes, they are. Market timing isn’t a possibility here, however, since North American investors don’t have access yet anyway.
Dan, I’m debating to move my VEE over to VWO or IEMG in my USD spousal RSP account, since I’m contributing a large proportion to my spousal, and currently hold VTI there.
I don’t see as great a difference in the dividends of VEE vs VWO as is evident with VUN vs VTI.
Is it correct to say VEE and VWO don’t have a difference in taxes on dividends? Thank you!
No need to reply Dan – I found your excellent white paper that has the details. Thanks!