The China Crackdown and the Index-Fund-Manager Conundrum✨

(ft the $FRDM index) 🧵
As we all know China has been cracking down on various sectors for the past few months (most recently, gaming) but the list is quite expansive
@Noahpinion had a really excellent piece on the why behind this -

‘It's not technology that China is smashing - its consumer-facing internet software companies that americans tend to label “tech”’

noahpinion.substack.com/p/why-is-china…
China has created somewhat of an internal mandate that tech = hard tech (semiconductors)

In the United States however, tech = consumer/social tech (Facebook, Google etc)
That's why almost every person appears to be building a consumer social app in the US - bc we conflate this type of tech with ALL types of tech.

And US investors carry their notion of consumer/social tech into investing in China - and the numbers show it
Chinese tech and education stocks have lost more than ~$1T in market cap since February.

An interesting thing is that Cathie sold - she sold before a lot of fallout
But while Cathie was selling, the indices were gathering

It ends up being this weird, convoluted cycle where the index ends up having heavy exposure to China - the fund issuers track that, managers track that, etc etc
Funds are thinking about how to solve this - BlackRock is thinking about separating China out as a stand-alone market, not part of EM or DM.

This will help with fund structure but it still doesn’t solve the ✨overexposure✨ issue.
There is

1. General overexposure: EM funds have massive exposure to China, mostly due to market cap weighting. ~VWO has 40% to China alone.
Intensive overexposure: broad EM funds are the biggest holders of $EDU. Not China-focused funds, not thematic education funds - broad EM funds
You might say - oh, I can just invest in an ESG fund and avoid the overexposure right?

EM ESG funds have the same exposure because of tracking error— they cannot deviate from the parent (non-ESG) benchmark by more than 1%.

So they end up with the same ✨overexposure✨ issue.
Zooming out here, this is a problem with fund structure-
The whole MSCI /China story and the global benchmarks inclusion is really interesting too.

wsj.com/articles/how-c…
The SEC has a paper on it - “more than 150 China-based companies with a combined market value of $1.2T were listed on US stock exchanges at the end of 2019.”

sec.gov/files/US-Inves…
There are three different classes of shares in China: A Shares, B Shares, and H Shares
A shares used to be *just* for mainland Chinese investors.

But now all 3 major equity index providers - MSCI, FTSE, and S&P have A Shares in their EM indexes.
According to the SEC this is a big deal for a few reasons
Dalio wrote a good piece about ~why~ the crackdown is happening but its still really tough for all the investors that are exposed

A lot of broad EM and thematic ETFs hold these companies - meaning that they are going to feel the pain

linkedin.com/pulse/understa…
So the deal is that there is an overexposure to Chinese companies in the EM indexes, then an increasing exposure to them due to market cap weighting, resulting in funds having overexposure, resulting in asset managers having overexposure
The main thing:
And OF COURSE check out $FRDM

lifeandlibertyindexes.com

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