ResearchEmerging Markets

KraneShares & Impact Advisors’ Chris Steward Discuss Advantages of EM Models

Impact Advisors’ Chris Steward joins KraneShares’ Jonathan Shelon to discuss why he decided to use the Krane Dynamic Emerging Markets Strategy for his clients’ emerging markets (EM) exposure. They also discussed why having a strategic allocation to EM is important, why China should be considered an asset class in its own right, and the advantages of owning EM through a dynamically-adjusted model portfolio.


Chris: Hi I’m Chris Steward Director of Investments for Impact Advisors Group we’re excited to announce our partnership with KraneShares in the emerging markets portions of our portfolios. And today I have the pleasure of talking with Jonathan Shelon, Chief Operating Officer of KraneShares. And we’re going to explain how the Dynamic Emerging Market Strategy works in our clients’ portfolios.

Good morning Jonathan.

Jonathan: Good morning Chris, thanks for having me.

Chris: So maybe we can take a step backwards and explain why it’s important for someone to have emerging markets in their portfolios at all?

Jonathan: Well, it’s interesting because there are a number of mega trends that take place in emerging markets that you don’t have access to oftentimes in the rest of the developed markets. For example, the emerging markets tend to have younger populations, they have rapid urbanization, and faster technological adoption, and so what this does is it creates this emerging middle class with rapidly growing incomes that lead to increasing consumption. And what’s happening now, and we’re seeing this in China and other emerging market countries, is that there’s this consumer upgrade that tends to focus on things like food, housing, and health care. So as people are moving to urban centers, they’re making more money, they want better qualities of life and this consumption is driving growth.

So historically GDP growth in the emerging market economies has been higher than GDP growth in developed markets, and we’ve seen this historically, but it’s also playing out we think in the next couple of years. In fact the IMF recently said that emerging markets should be growing around five percent over the next two years but developed markets are at about four percent this year and two and a half percent next year.

And kind of the last comment I’ll make has to do with opportunity set. People don’t realize but right now the emerging markets have grown to a point where they represent about a quarter of the world’s equity market cap. So it’s interesting if you’re not investing in emerging markets you might be avoiding one full quarter of your opportunity to make returns. And given what we saw last year was this diversion divergence between U.S and emerging market performance. U.S was up 26% while emerging market equities were down 3%. The emerging markets are relatively cheap right now absolutely. Certainly diversification is one of the big arguments for investing in emerging markets.

Chris: Let’s turn a little bit towards China. I know you guys are China experts. 16 years ago when MSCI launched their Emerging Markets Index China was about one percent now it’s 36 percent. But if I understand correctly, if you included China at its full market capitalization it would be much larger. Maybe you can explain that?

Jonathan: Sure! So there’s this really interesting history because even though China has the world’s second largest equity market, the Shanghai Stock Exchange only opened its doors in 1990 – so it’s only about 32 years old. And it took a long time for China to show up in benchmarks like MSCI emerging markets and MSCI China, which are the most widely used by institutions. In fact, part of this was because it took 12 years for China to open up its markets it wasn’t until 2002 that the Chinese government created special permission that allowed foreigners to invest in Mainland stocks and that was called QFII quota. And then it took another 12 years all the way to 2014 for the Stock Connect Program to get established and that allowed anyone with a Hong Kong brokerage account to invest in mainland Chinese stocks. And so even though China has the world’s second largest stock market, about half of those, half of that value, is in the A-shares that we call the Mainland stocks and those are on the Shanghai and Shenzhen exchanges. Another 40% of the value is in Hong Kong and the rest are companies that are actually listed on the U.S stock exchange.

So the challenge is it took these global benchmarks like MSCI China a while to capture what was happening here with these trends and right now MSCI China is only reflecting about 20% of the value of the A-share market of this mainland market. That’s a huge haircut to what the actual opportunity is and so even though emerging markets are saying about a third should be in China, if you take into account the full value of what’s available to global investors, the right number is somewhere in the mid to high 40s all the way up to 50 percent. And we think there’s going to be a point in time, and I can’t give you the exact year, where China may be more than 50% of the emerging market category.

Chris: wow wow! So I think most investors, even professional investors, RIAs, get their China exposure through a diversified emerging market strategy. Can you explain why you are coming down so strongly on China as its own asset class?

Jonathan: absolutely! We’ve done a lot of research in thinking about what it means to be an asset class and whether or not China meets these criteria. And the first one, there are several reasons, the first one is size. We talked about China being the second largest stock market in the world second only to the U.S and roughly half of the emerging market opportunity. What that means is if you allocate 15 to 20 percent to emerging markets, which we find to be pretty common, you could have a China allocation that should be seven and a half to ten percent. That’s a lot! That’s certainly enough to treat China as a separate category. It’s a big part of the portfolio.

The China stock market now is also widely available and investable from around the world. So it’s becoming more institutionalized. Much more involvement from pension plans endowments family offices sovereign wealth funds. So you can you can invest in it in a way now that you couldn’t even 10 years ago.

And the last piece, I would say has to do with impact, right. Breaking China out only matters if it could affect your portfolio. And what we found is that China has a low correlation to developed markets, less than 0.6, which is quite low, and has a low correlation, less than 0.7, to the rest of emerging markets. What this means is that even though China is on the margin more volatile than the rest of emerging markets, when you combine it within a portfolio and use really representative weights, again in this 40 to 50 percent range, you can actually increase return, reduce risk, or do a little bit of both.

So the last point I’ll make that is really important is that China is still a relatively young and inefficient market and we see a lot of what’s called alpha opportunity, or outperformance opportunity, and that could be achieved either at the portfolio construction level, which is something that we do, but also through thematic investing, in stock selection. So a lot of different reasons why China should be broken out as its own separate category. But to do so it does require additional expertise.

Chris: Yeah so growth in China has been slowing, not unexpectedly, the market is maturing, but there seem to be some great opportunities there as the economy shifts from kind of old style materials manufacturing base to some new things technology etc. Maybe you can hit that point also?

Jonathan:  Sure! Yeah. What’s really interesting is a lot of people think of China as like the manufacturing center of the world. And it still is a powerhouse in manufacturing, but if you look at manufacturing within China’s own economy, it actually has transitioned over to services, and it’s starting to look a lot more like the U.S. In fact, back in 2015 was the first year where the service sector of China’s economy represented more than 50 percent of its GDP. So they’ve been majority services oriented now for over seven years. And the other thing that’s really interesting is that despite rapid urbanization, that I touched on before, happening in emerging markets and in China, it’s only in the sixth inning. China is only 60 percent urbanized. And what that means is that only about 70 percent of China’s population has access to the internet now. Compare that to the U.S in the U.S we have much higher urbanization and 90 percent internet penetration. But despite all that, you know, China actually has three times as many internet users because of the size of the population.

And what else I find fascinating is demographics. China has more millennials than there are people in America.

 Chris: wow that’s an interesting stat!

Jonathan: There are 400 million millennials in China about a quarter of them have college degrees, but they don’t carry student debt loads the way that a lot of our folks here do because the cost of college in China is much cheaper. So you know, you’ve got this really interesting combination of factors that could continue to propel growth, not manufacturing growth, but really technology adoption, and what we call leap frogging. Because you have this young population urbanizing, having more wealth, there have been technological adoptions that have happened very quickly. For example in payments, China is largely a cashless society, they never really had credit cards. Credit cards never took off. They’ve been using QR codes to pay for things for the longest time. It took us COVID to start using other cashless payment systems in the U.S, other than Starbucks, but China’s been doing cashless payments for years and years. the same thing applies to commerce they don’t really have big box stores they never needed to they went right to e-commerce and they’re seeing rapid technological adoption and transportation and healthcare much like we do here in the U.S.

I think you almost have to look at China through a different lens, a future lens, which is really all about service consumption and technological advancement.

Chris: Well so as I mentioned we’re really excited to be launching this partnership with you guys I think it’ll really help our client portfolios. Maybe you can take a few minutes and talk about KraneShares itself?

Jonathan: Absolutely. So KraneShares was founded over 10 years ago by Jonathan Krane. And Jon’s an entrepreneur. When he graduated from Columbia business school he actually moved to China. So an American moving to China to start a business, and he focused his business on live entertainment and sporting events and became this bridge for world-class performers to enter into China.

Prior to that time you didn’t really have a lot of kind of imported sporting events and entertainment, but Jon made that happen there. And towards the end of the early 2000s he exited that company by selling it to a large multinational and returned back to the states. And when he came back to the states he was like, “how do I tap into, from a capital market standpoint, all those opportunities that I observed when I lived there? How do I take advantage of technological advancement, and urbanization, and consumption, and all the things that I was part of when I lived there? And when he started asking around people said, “well no you can’t do that China’s hard to invest in, and it’s opaque, and all you know a million reasons why,” and there’s nothing that an entrepreneur loves to hear more than, “no you can’t do that,” and so he immediately said, “I want to give people the ability to invest in China in a very transparent way, in a way that leverages not just the broad representation, like a lot of these benchmarks provide, but into specific themes areas that I think are going to be the best performers in the coming decade.” And so he settled on having us create an ETF company. And that’s what we did.  

So KraneShares is a US-based, but China-focused, ETF firm and for the first 10 years since our founding we focused a lot on why China? You know, why should I treat it as an asset class – like the conversation we’ve been having – but I think the next 10 years is really going to be all about the how because more and more of our clients are saying, “I’m with you, I get it, we need to own China as its own category, but how do I do it? How do I make that efficient? And that’s kind of where we are now as a business.

Chris: Yeah, so let’s turn to the strategy we’re using. We’re investing not just in your ETFs but in an actual model called the Krane Dynamic Emerging Market Strategy. Now when I think of a model, I often think of a quant black box, but that’s not the case here. Maybe you can talk about how it’s designed and how it works?

Jonathan: Absolutely so we wanted to make sure that this model captured our philosophy which is this notion of taking China as an asset class, but we also recognize that when you look at China with the rest of emerging markets and compare them that those weights don’t have to be the same over time. So you don’t have to always have 30 percent or 40 or 50 percent invested in China. We think that there’s opportunity to do better by having those weights change. And the proof of that is in the pudding.

If you look at the last three years over the full three-year period China’s up about 14% on average and the rest of emerging markets is up about 13%. So you’d say well that’s not that different, why bother, right? Well the truth is if you look at the year-by-year differences in 2019 there was a 10 percent difference between China and the rest of emerging markets, and in the last two years that difference was upwards of 20 percent. So you don’t need to capture a big part of that difference to add value. You don’t have to you know try to get all 10 or 20% between these two. But if you can do something that is thoughtful and transparent then you might be able to extract a couple of percent, and so our model uses valuations and fundamentals to determine the weight to China versus other emerging market countries based on three factors relative valuations and this looks at things like price-to-book and forward p/e and long-term growth. But we also look at severe events, market dislocations, because markets can move quickly, this is a volatile space, and so in these extremes there’s opportunity to overweight and underweight China versus the rest of emerging markets.

And then we also wanted to have a bit of a shock absorber built in, because you know even though there’s opportunity when markets decline, there’s also downside risk. And so even though this is a designed to be an equity portfolio we’ve given ourselves the flexibility to have up to 10 percent in cash when we’re seeing rapidly deteriorating market conditions. And we use moving averages to do that.

Chris: I think that maybe you can talk about how the strategy performed during, shall I call it the COVID crash March of 2020?

Jonathan: Sure, and this is really interesting because we launched this model in late 2019. We had no idea that we were about to stumble into COVID and that we were going to have like – we tested the model over a 10-year period so we had a sense on how it might do in different conditions –  but we did not expect in the first three months of our model in with real money to you know really experience the kind of volatility that we saw. And just to explain a little bit more about how the model works, it’s really designed to rebalance quarterly. So four times a year we rebalance between China and the rest of emerging markets and establish weights on average you would expect our weight to China to be about 40 to 50 percent in line with what we believe is the representation, but we give ourselves 30 percent flexibility. So it’s a considerable amount of flexibility that we have to be overweight or underweight, and then we talked about 10% cash in times of stress. So here’s what’s really interesting, in 2020 instead of doing the four quarterly trades that we thought we would do, we actually did seven rebalances all together. So we did the four quarterlies and three additional ones. And these three were really important. The first one happened at the end of January of 2020, it was our first ever stop-loss trigger, basically our model said go to 10% cash, and we didn’t feel good about it because if you remember back in January of 2020 people thought – you know this COVID thing it’s gonna be gone before you know it, it’s not that big of a deal, and so we were like geez no this is a great opportunity to buy! Why are we moving to cash? But we really want to be rigorous and thoughtful and not override the model, that’s not why we built it, we built it to be systematic and provide real quality in what we do, so we moved to 10% cash in January of 2020, and if you look at the performance of the underlying investments that we had in that first-quarter China was down about 11% and the rest of emerging markets was down 30% percent so our strong weighting to China allowed us to outperform emerging markets broadly by about five percent. So going back to your comments Chris you know it was this asymmetrical return that we were able to produce in that period. Partly because of the cash position and partly because of our overweighting to China versus the benchmark.

Now it’s not to say that we made money, we didn’t, we lost money, much like emerging markets lost money. Emerging markets were down 24% but we definitely did better, and we did better at a time when people I think appreciated it.

Chris: Well Jonathan that’s fantastic. I’m sure our clients can see why we’re really excited about this partnership. It’s obviously a passion for you and your group, and I’m sure that we’ll all benefit from it down the road, and again thank you for your time today.

Jonathan:  Chris thank you! We’re really excited about the role that China and emerging markets can play. As you can tell we really are passionate about this, and we think there’s a lot of opportunity and we’re going to continue to work hard in managing the Dynamic Emerging Market Strategy and look forward to building on our track record and serving your clients.

Chris: Thanks again!

Jonathan:  thanks, Chris!