Past performance does not guarantee future results. Indexes are unmanaged baskets of securities in which investors cannot directly invest; they do not reflect the payment of advisory fees or other expenses associated with specific investments or the management of an actual portfolio.
International and emerging markets involve additional risks, including, but not limited to, currency fluctuation, political instability, foreign taxes, and different methods of accounting and financial reporting. As a result, they may not be suitable investment options for everyone. Emerging Markets represents securities in countries with developing economies and provide potentially high returns. Many Latin American, Eastern European and Asian countries are considered emerging markets.
March, 2014: MSCI’s China A-share Index (MSCI China A International Index) Hovers Around $28001
At the time of the above headline, index provider MSCI announced a roadmap to add China A-share to its Emerging Markets Index in 2015.2 I personally recall this announcement being a big deal! Why? Well, the Chinese A-share marketplace is notorious for discriminatory quotas against foreign investors, among other detractors.
This was a significant decision for a $1.7 trillion index as it implied that roughly $22 billion would be invested in China by fund managers based on the new, estimated 1.3% index weight to China A-shares.3
The MSCI Emerging Markets Index’s regular exposure to China is around 25.3% and that includes B-share, H-share, Red Chip and P Chip. You might recognize some of the largest ETFs tracking this EM Index such as EEM (iShares Emerging Markets ETF).
May, 2015: MSCI sets June 9, 2015 As The inclusion Date – The China A-share Index Spikes Some More
June, 2015: MSCI’s China A-shares Index Hits Over $7200 — An Unprecedented 157% Growth In One Year Since MSCI’s Announcement To Add China A-share1
Surprisingly, on June 9, MSCI announced that it would defer the inclusion of China A-share until remaining obstacles regarding restrictions on foreign investing could be worked out.4
Within just a few days of MSCI’s deferral announcement, MSCI’s China A-share Index began a free fall. By the end of August, the index had plummeted to the $4400 handle — a 40% drop in just two months.1
Correlation doesn’t equate with causation. And in this case, we can’t fully explain the spike or the correction in the China A-share market.
However, it does make us pause and ask: Looking solely at the performance of the MSCI China A-share Index since inception, did the 2014 MSCI inclusion announcement help create the huge run up in the China A-share market?
Conversely, did the 2015 MSCI deferral news contribute to the China A-share drop?
If MSCI had included China A-share as originally announced, what effect would that have had on investor returns in Emerging Market Index Funds and ETFs that track the MSCI EM Index? Would these indexed funds have purchased a peak right before a plummet?
Luckily for foreign/western investors, this did not happen!
Here is what does happen with Indexing:
- Index reviews and reconstitutions are done on set dates. Furthermore, indices have to telegraph their reconstitutions, which can drive external front-running and arbitrage activity.
- Index Funds and ETFs that track indices do so with a goal of zero tracking error; therefore, they are constrained from updating their portfolios continuously.
- They also can’t be patient in their trading to attain efficiency. Instead, they have to patiently wait for each index reconstitution. More plainly, Index Funds and ETFs are chained to their index. Most of the time that works fine, but occasionally, it’s worthwhile for us to take a deeper look.
The “MSCI China A-share” story tells us that tracking an index has handcuffs that need to be better understood.
A picture is worth a thousand words as you can see from the chart above! These are the things that make you go Hmm … and why we prefer our approach to Asset Class Investing over Indexing.
Sheldon McFarland will present “Asset Class Funds vs. ETFs: The Latest Research on Return Factors and Smart Beta” at his applied session during our National Education Conference (NEC) in October. For more information, please visit: www.2015nec.com
Implementing an Asset Class Investing or Indexing strategy cannot guarantee a gain or protect against a loss.