Love Emerging Markets But Fear China? No Problem! (XCEM)

It’s amazing how fast Wall Street turns on momentum plays when the going gets rough. The latest victims? Chinese stocks.

Love Emerging Markets But Fear China? No Problem! (XCEM)The last few weeks have been brutal for China’s markets. A bubbly stock market and questions about its growth in the near-term have curbed investors’ appetites (both domestically and globally) for stocks from the Far East.

As such, China has seen its Shanghai Composite fall about 40% since reaching its peak in June. In fact, when the bubble first burst, the Shanghai lost 32% of its value in just 18 trading sessions.

That has promoted Beijing to do some crazy things to prop-up flattering Chinese stocks. But with investors still bailing, a new ETF has launched that could potentially eliminate China from your portfolio altogether.

But is that really a good idea?

An Obscure Provider Gets Even More Niche

Emerging Global Advisors has built its business around emerging markets, which are the only exchange-traded funds it offers. Those include some pretty niche offerings, such as single-country infrastructure funds and the uber-popular EGShares Emerging Markets Consumer ETF (ECON).

The problem is, what do you do when the biggest emerging market of them all is flat-lining? The answer: Kick Chinese stocks to the curb.

The new EGShares EM Core ex-China ETF (XCEM) does just that, eliminating exposure to China and Hong Kong from its portfolio.

The new ETF tracks the EGAI Emerging Markets ex-China Index, following up to 700 different emerging market companies domiciled in 20 developing countries, including: South Korea, Taiwan, Brazil, India and South Africa. The fund will not hold any Chinese stocks — be they A-shares, Red Chips, H-shares or whatever — in its portfolio.

While the timing for XCEM is perfect due to meltdown in Chinese stocks, the concept behind the XCEM ETF comes from a longer-term trend. China is already a huge player in emerging market indexes, and China is only getting bigger.

According to EGA, the two biggest emerging market benchmarks — the MSCI Emerging Markets Index and FTSE Emerging Index — are already laden with Chinese stocks, exposed to 25% and 28%, respectively. Those are awfully big numbers, and they should get even larger from here. The former is considering adding Chinese A-Shares to its EM benchmark and the latter already has plans to — when they do, those numbers will rise to 44% and 40%.

That means investors in two of the most popular ETFs — the Vanguard FTSE Emerging Markets ETF (VWO) and the iShares MSCI Emerging Markets ETF (EEM) — are going to hold a lot more China than they realize.

That’s where XCEM comes in. The basic idea is that having 40% exposure or more to any one nation may not be such a good idea. By using XCEM, investors can choose their own exposure to Chinese stocks, whether through straight indexing, active management, exposure to A-shares ETFs or a combination of the three.

If you only want China to be 5% of your emerging market portfolio, go for it. And in light of the recent market turmoil in china, if you’d like no exposure whatsoever, you now have that option as well.

And with an expense ratio of 0.35% ($35 per $10,000 invested annually) until Aug. 11, 2017, XCEM makes an interesting choice for your core emerging market holding.

So Should You Buy XCEM?

If you want to invest in emerging markets, eliminating Chinese stocks does seem like an envious position given China’s recent market mayhem. The question is whether it’s going to be great over the long-term.

As we’ve said, China is the emerging market, and is one of the largest economies on the planet. It’s the main driver of the commodities markets, and its economic growth — even in its contracted state — is still enviable against the rest of the world.

China has a massive population that is ready to consume. And as the emerging market, China has been responsible for the underlying benchmark indices biggest long-term returns. The key words being “long term.” That is what emerging markets and Chinese stocks are all about — long-term investing.

And as for those A-shares, MSCI predicts that combining them with “regular” Chinese stocks will still only account for about 65% of its total gross domestic product. Meaning you’re not going to capture all of China’s potential even when those A-shares are included in its benchmark emerging market index.

So using XCEM as a way to completely remove China doesn’t make sense, but for skittish investors, using XCEM as a way to reduce your exposure to China does make a tad bit of sense, although it’s not perfect.

With the XCEM ETF, you now gain a huge slug (19%) of South Korea, which is more developed than some parts of the United States. Same goes for Poland and Taiwan — both these nations are on the cusp of being considered “developed.”

But if you’re a skittish investor, you probably shouldn’t hold volatile emerging markets in the first place.

The Bottom Line: With the recent rout in Chinese stocks, investors could take a look at the new XCEM ETF. They may, however, only want to give it a passing glance.

As of this writing, Aaron Levitt did not hold a position in any of the aforementioned securities.

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