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China Grabs A Bigger Share Of The Indexes

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 (NYSEARCA: 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 (NYSEARCA: 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 share 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.”

How Long Before ‘They’re Raising Rates’ To ‘They’re Considering QE4?’

If foreign economic stagnation and commodity price depreciation is an old story, then why are U.S. equities suddenly responding as though the U.S. economy might be in danger? The daily volatility over the last 10 weeks is primarily attributable to the Federal Reserve terminating its third iteration of “QE” back in October. The central banks of the world have been remarkably successful at repressing the risk of equity market participation. The media are telling us that U.S. stocks have been under pressure this January due to global growth fears and an accompanying rout across the entire commodity space. Yet that only tells a small part of the story. After all, the S&P 500 SPDR Trust ETF (NYSEARCA: SPY ) has performed quite admirably over the past three years, blissfully unresponsive to the global growth woes reflected in ETFs like the Vanguard FTSE Emerging Markets ETF (NYSEARCA: VWO ) and the iPath Dow Jones-UBS Commodity Index Total Return ETN (NYSEARCA: DJP ). If foreign economic stagnation and commodity price depreciation is an old story, then why are U.S. equities suddenly responding as though the U.S. economy might be in danger? Where’s the enthusiasm for the enormous stimulus associated with cheap oil and gas? What happened to the euphoria over the best job growth since 1999? In truth, the daily volatility over the last 10 weeks is primarily attributable to the Federal Reserve terminating its third iteration of “QE” back in October – an electronic money creating, bond-buying program that resulted in the Fed acquiring trillions in U.S. debt. Consider the reality that when the Fed removed a large portion of the supply of treasuries, investors who would have bought those treasuries had to buy assets like corporate bonds instead. This reduced the borrowing costs for corporations and allowed many of them to refinance debts as well as buy back shares of their own stock. Up went the stock market. Similarly, the Fed removed a large portion of the supply of mortgage-backed securities, ultimately lowering the mortgage costs for real estate. Up went the housing market. An increase in the net worth of corporations, small businesses as well as wealthier families did create an atmosphere for greater economic confidence. However, with the Federal Reserve hinting that overnight lending rates might go up as soon as April, butterflies flapping their wings in Rio de Janeiro and Beijing have been creating tremors for U.S. equities. In essence, the stock market is not so sure that our “booming” domestic economy is a self-sustaining wonderland in the absence of central bank stimulus. Nowhere is this more obvious than in the relatively tranquil progress of the FTSE Custom Multi-Asset Stock Hedge Index. In the ten weeks since QE ended (through Jan 14), the index has quietly gained 2.5% while the S&P 500 has fluctuated wildly on its way to being flat. (Note: These results do not yet account for Wednesday’s stock declines.) While the bullish media typically ignore the bulk of what happens with non-equity asset classes, there are specific currencies, commodities and country debt that have historically performed well in moderate-to-severe stock downturns. Asset types like longer-term treasuries, zero-coupon bonds, munis, German bunds, gold, the franc, the yen, the dollar and others fit the bill. The index, often referred to by others as the “MASH Index,” does not short or use leverage like a bear fund; safer haven holdings (ex stocks) often perform better than cash in stock uptrends as well. You can learn more about the FTSE Custom Multi-Asset Stock Hedge Index at StockHedgeIndex.com . Those investors who remain in the bullish camp theorize that the U.S. economy is strong enough to handle modest rate increases. They also anticipate the inevitability of quantitative easing or similar asset-back purchasing measures in the euro-zone as well as China acting to bolster its economic output through a variety of techniques; stock bulls view the troubles overseas as noise and vow to continue buying dips on weakness. In contrast, bears counter with the fact that U.S. stocks are not only at the high end of historical valuations, they may be at the highest levels in recorded history. For instance, Jim Paulsen at Wells Capital explained that U.S. stocks have never been this expensive ever, at least not when one employs the median price-to-earnings ratio. (And Paulsen has been a fixture in the bull camp!) My view? I am neither bullish nor bearish in practice. That said, I am a proponent of applying insurance principles to the investing process. Stop-limit loss orders , trendlines, put options, multi-asset stock hedging – they all minimize the risk of catastrophic loss. Indeed, the reason I partnered with the world’s largest index provider (FTSE-Russell) in developing the FTSE Custom Multi-Asset Stock Hedge Index was to offer a new way to reduce the risks associated with stock market euphoria. The central banks of the world have been remarkably successful at repressing the risk of equity market participation. Throughout the six years of the 2009-2015 bull, whenever there has been a belch (or even a hiccup), the Federal Reserve has come to the rescue with more bond-buying stimulus. On the flip side, if they stick to their guns on raising rates this time, you can expect the uncertainty to fuel even more desire for perceived safe havens. You might look at the iShares 10-20 Year Treasury Bond ETF (NYSEARCA: TLH ) as well as carry trade reversal beneficiaries like the CurrencyShares Japanese Yen Trust ETF (NYSEARCA: FXY ). If the conversation shifts towards “no rate increases until 2016″ or even “a bit more QE is a possibility,” then the unbridled excitement for stock ownership would pump new life into the aging bull. Disclosure: Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. Gary Gordon, Pacific Park Financial, Inc, and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising at the ETF Expert web site. ETF Expert content is created independently of any advertising relationships.