What the China crackdown could mean for your portfolio

China is the second-largest economy in the world, making up about 17% of worldwide GDP, surpassed only by the U.S. It was the only major economy to post growth figures in 2020. The Chinese equity market, while young, topped the $10 trillion threshold last year, and its corporate fixed-income market is around $9.4 trillion. 

This kind of growth has been appealing to investors. Through December 2020, China’s CSI 300 Index, which tracks 300 A-share (read: domestically traded in China) stocks listed on the Shanghai or Shenzhen stock exchanges, trounced the S&P 500:

But the numbers aren’t too pretty right now, as a series of sweeping regulatory actions from the government signals more intervention lies ahead—at least for certain sectors. China has homed in on its big tech companies, and it’s seeking to address quality-of-life issues like gaming addiction, or cracking down on education companies trying to profit on after-hours tutoring. 

All of this has spooked markets. Nearly $1 trillion of value on the Chinese exchanges had disappeared. Stocks of China’s biggest tech companies have been plummeting: ADRs of Alibaba Group were down nearly 24% at market close on Sept. 1 from the beginning of this year. China’s biggest food delivery company and shopping platform, Meituan, was down nearly 10%. The Nasdaq Golden Dragon China Index, which tracks the largest Chinese companies (or affiliates) trading in the U.S., is down nearly 24%. Some asset managers (including Cathie Wood’s ARK Invest) are headed for the door. SoftBank said it was suspending its investments in new China startups. 

Here’s a second comparison (again, of Chinese companies trading onshore), this time through the end of August 2021:

The million-dollar question lies in whether new regulation in China points to a strategic change in focus—toward more dramatic private market intervention and wealth redistribution—or just another sequence of coordinated policies all lodged at reshaping a few specific sectors. These targeted regulatory initiatives are common in China, says Jason Hsu, founder of Rayliant Global Advisors, which invests around $250 billion in U.S. assets in China for American institutional investors. And stock swings often follow, Hsu says.

“You do see markets overreact to good news from time to time, and right now overreact to negative shocks. From that perspective, it’s very predictable,” he says. “We’ve seen that cycle play out I would say once every five years.”

Either way, investors should know about the potential impact to their portfolios.

Didi, data, and VIEs

First a little background. Back in November, China pulled the plug on what would have been the world’s largest IPO: digital payments behemoth Ant Group, which was expected to hit a $310 billion valuation after going public on the Hong Kong and Shanghai exchanges. Following that, regulators launched a probe into Alibaba (later fining the company a record $2.8 billion). There was the ignominious U.S. IPO of Chinese ride-hailing app Didi Chuxing after it reportedly ignored warnings that it should put a pause on its plans to go public. In July, China banned education companies from making money on after-school tutoring or raising capital, essentially turning all the companies in that sector into nonprofit organizations.

China approved a new data data privacy law, which will become effective by early November. This month, a separate law goes into effect that gives President Xi Jinping the authority to fine or shut down the country’s largest tech firms. There have been new anti-monopoly rules lodged at tech giants, new draft guidelines for Internet companies over anticompetitive activities. I’ll also mention that Tesla cars were banned on military properties due to their cameras collecting data. Just last week, the government moved to restrict hours children can spend gaming each day (say goodbye to those glazed-over eyes).

The initiatives tend to be heavily focused on data privacy and national security. Big tech companies are at the forefront, as are the gaming and once for-profit education sectors (bye-bye, Duolingo).

Let’s be clear: Investor uncertainty isn’t new for China, nor for any emerging-market nation for that matter. “There’s political, economic, and regulatory uncertainty in emerging markets on a relatively frequent basis,” says Will Collins Dean, a senior portfolio manager at asset manager Dimensional Fund Advisors. “The best way to mitigate risks is through diversification, in our view.”

How exposed are investors to these losses in China, anyway? That’s where it starts to get a little complicated.

Hidden in the Cayman Islands

American investors have two types of exposure to China. There are the China onshore investments (as charted above), which are the companies listed on local exchanges. Then there are the offshore investments. 

The U.S. has hundreds of billions of dollars invested in entities tied to Chinese companies that are set up in the Cayman Islands and trade on U.S. exchanges. They are affiliated with Chinese companies and offer exposure to them, but they don’t actually hold any shares. Because Chinese regulators restrict, or prohibit, companies in many industries from listing on foreign exchanges (the Internet industry, for example, is off limits), it’s become a common alternate route for the last 20 years to set up what’s called a variable interest entity, or a VIE. This helps Chinese startups attract U.S. venture capital by making a clear path to work around Chinese legislation and list on U.S. exchanges. Peking University research from 2019 shows that a majority—or 69%—of Chinese companies trading on the NYSE and Nasdaq are utilizing the VIE structure. Count Alibaba Group and Didi among the companies that have made it happen this way. 

China has historically “turned a blind eye” to these structures, according to Hsu. “They realize [VIEs] made venture capital available to Chinese companies. That’s obviously critical for innovation, for supporting young great entrepreneurs and great business ideas.”

But in early July, China laid out plans to more closely review companies that planned to go public on foreign exchanges. The Securities and Exchange Commission also said earlier this year that it would crack down on disclosure requirements for VIEs, as it isn’t clear to U.S. investors that they are investing in shares of shell companies, rather than the companies themselves, the SEC said. This newfound regulatory attention on VIEs is likely a major contributor to the poor performance of the Nasdaq Golden Dragon China Index this year.

Exposure

The VIE structure skews data on investor holdings in China—at least on paper. U.S. Department of Treasury data shows that investors have, on average, approximately 2%—or $287 billion—of their foreign investments in China. But that isn’t the full picture. When you incorporate VIEs into the equation, U.S. equity investment in China is more than four times what is listed in the official statistics, according to research from the Global Allocation Project. 

To be clear, Chinese equities and bonds are still a small portion of investor portfolios. U.S. investors are significantly more weighted in advanced markets. They tend to only have somewhere closer to 4% China exposure in their portfolios, according to Dean. At the end of June, the top 10 asset managers in the U.S. each had less than 5% of their total invested assets in open-end mutual funds and ETFs held in Chinese equity or fixed income, according to Morningstar Direct Data. State Street had less than 0.75%.

But even 4% exposure can be meaningful when some equity markets are performing so poorly, particularly depending on which companies (or VIEs) investors have exposure to.

Below, let’s look at the performance of the MSCI China A Index, which tracks onshore investments in China, versus the MSCI China Index, which also includes offshore investments. Offshore investments tend to be more heavily weighted in consumer technology, Hsu tells me.

Some strategies professional investors are taking: Hsu says Rayliant Global Advisors is avoiding investments in Chinese tech companies, and avoiding offshore investments by steering clear of VIEs. Dimensional Fund Advisors portfolios are currently emphasizing small-cap Chinese companies, and focusing more on profitability than size.

For investors who are still bullish on China but have concerns over the future performance of its tech giants or other sectors, there are still ways to navigate the Chinese markets and steer clear of specific areas of concern. The Global X MSCI China Health Care ETF (CHIH) invests in large-cap and midcap companies in China’s health care sector. That’s trading at about the same levels as it was in January. (For comparison purposes, the MSCI Emerging Markets Index is up about 1.6% mid-afternoon Sep. 2.) The iShares MSCI China Small-Cap ETF (ECNS) seeks exposure particularly to small-cap companies and avoids larger corporations in China. That fund is up more than 10% year to date. Another viable option may be funds that track China mainland markets, which are more heavily weighted in state-owned companies and less saturated in tech. The iShares MSCI China A ETF (CNYA) and KraneShares Bosera MSCI China A Share ETF (KBA) have still suffered this year (down 1.86% and nearly 2%, respectively), but have been more resilient this year than funds that include foreign investments, such as the Invesco Golden Dragon China ETF (PGJ), which is down more than 23% since January.

Of course, some investors may have deeper underlying concerns and decide they want to start avoiding Chinese investments altogether, in which case there are still options for exposure to other emerging markets, while limiting holdings in China. The iShares MSCI Emerging Markets ex China ETF (EMXC), for instance, is up more than 9% this year. That fund reeled in more than $300 million the first two weeks of August.

A suggestion to investors: Don’t do anything drastic. “You don’t want to be a seller right now,” Hsu says. “But you also don’t want to jump in and buy at the dip, just because there are going to be more policy announcements. That’s just a pattern in policymaking in China.”

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WEEKLY CHART

JARGON, EXPLAINED 

“ADR”—Also known as American Depositary Receipts, ADRs are certificates handed out by a U.S. depository bank that represent a certain number of shares in a foreign company’s stock. The certificates trade on a U.S. exchange, while the bank holds the underlying securities. VIEs utilize ADRs to trade on American exchanges.

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Liking this column? Have an investing query you’d like to see this column tackle? Send me your thoughts and feedback below. Thanks for reading. 

Jessica Mathews
Twitter: @jessicakmathews
Email: jessica.mathews@fortune.com

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