Currently, China onshore and offshore equities represent benchmark weights of roughly 0.4% and 4%, respectively, in global portfolios. These small weights are largely a result of complex index inclusion rules focused on access, regulation, governance, and liquidity considerations; index providers do not specifically consider the investment thesis for including Chinese stocks in global benchmarks. In this article, we critically examine the most popular investment arguments in favor of a greater allocation to China onshore and offshore equities, as well as skeptical counterarguments to these claims. China is large in terms of GDP and market capitalization—so what? China’s GDP growth is projected to be 5% higher than developed markets—but there is no empirical relationship between GDP growth and equity market returns. Chinese equities have lower correlation with global markets—but they also have much higher volatility, calling into question the diversification benefits investors seek. The Chinese stock market is filled with non-professional retail investors—but does that lead to greater alpha, and can investors capture that through long exposure to a market with questionable accounting and large differences in regulatory practices? We settle these debates through hard data and straightforward empirical tests. <b>TOPICS:</b>Emerging, private equity, portfolio theory, portfolio construction, equity portfolio management, mutual fund performance <b>Key Findings</b> • A number of popular arguments for including more Chinese equities in investors’ equity portfolios are based on the size of China’s GDP, the size of China’s equity market capitalization, or the growth in China’s GDP. These considerations do not appear to be correlated with portfolio returns or risks. • However, other arguments based on low correlation, faster corporate earnings growth, and high potential for alpha can be empirically verified and do provide meaningful return-risk improvement to investor portfolios. • China is one of the very few economies in the EM basket that has delivered high earnings growth and high equity return against the backdrop of strong GDP growth. This is generally not observed in other EM economies. • China onshore equities have a surprisingly low correlation with its own offshore listed equities and with global equities. The onshore equities historically also have provided faster earnings growth and higher returns than the offshores shares. The heterogeneity between onshore and offshore shares makes the current 90%/10% split between offshore/onshore shares dictated by mainstream indexes suboptimal.
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