The Pros and Cons of Investing in China

Vanguard has filed a prospectus for an Emerging Markets ex-China ETF, joining a growing trend of funds excluding Chinese equities due to concerns about the country's slowing economy, political tensions, and shareholder rights; while China represents a significant portion of global GDP and the MSCI EM Index, and can offer diversification benefits due to its low correlation with other markets, its state-owned enterprises and regulatory environment have historically led to lackluster long-term returns and concerns about investor protection, making the decision to include or exclude China dependent on individual investor priorities.

Analysis

Vanguard's recent prospectus filing for an Emerging Markets ex-China ETF underscores a growing investor inclination to decouple Chinese exposure from broader emerging market strategies, a response to China's equity market suffering double-digit losses in 2021, 2022, and 2023, a slowing domestic economy, and escalating U.S.-China political and trade tensions. This development aligns with an existing trend, with approximately 20 ex-China fund offerings already managing around $17 billion in assets. Arguments for maintaining China exposure highlight its significant economic footprint (19% of global GDP, 28% of MSCI EM Index) and historical periods of strong returns, such as the 60%-plus gain in 2009, alongside valuable diversification benefits evidenced by a low 0.12 correlation with the U.S. market over the trailing three years through May 2025. However, compelling counterarguments exist, notably the 'Emerging Market Fallacy' where robust GDP growth, particularly in China with its prevalent state-owned enterprises, does not consistently translate into proportional earnings per share growth for investors. Persistent concerns include governance issues like related-party transactions, questionable capital allocations, the overarching influence of the state, and regulatory unpredictability, even with recent legislative efforts like the July 2024 Company Law aimed at improving shareholder rights. The long-term underperformance of Chinese equities is stark: a hypothetical $10,000 investment in the MSCI China Index since 1993 would have grown to about $16,400, compared to $88,000 for the MSCI EM Index. Strategies excluding China, such as the Freedom 100 Emerging Markets ETF (FRDM), which focuses on countries with stronger shareholder rights, have shown superior performance, with FRDM ranking in the top 5% of its category over the past five years.

Key Decisions for Investors

• Investors should critically assess their risk appetite for China's unique political, regulatory, and governance landscape against its potential for diversification and growth, noting the historical disconnect between its economic scale and long-term equity returns.
• Consider utilizing ex-China emerging market ETFs, such as Vanguard's proposed fund or existing options like FRDM, to maintain EM exposure while mitigating specific risks associated with Chinese equities, a strategy that has demonstrated favorable outcomes in recent years.
• Closely monitor China's evolving regulatory environment, the tangible impact of reforms like the new Company Law on shareholder protection and corporate governance, and the performance of both China-inclusive and ex-China EM strategies to inform allocation decisions.