WisdomTree Research market insights [ September 2012 ] Managing Risk In China s Equity Market [ Major China Equity Indexes Have Significant Concentration Risk in the Financial Sector ] By Jeremy Schwartz, CFA, director of research, Christopher gannatti, Research analyst, & Chris jabara, research analyst China has been one of the most sought-after destinations of emerging market investments over the past decade. The country s economic growth has averaged double digits over this period, and although growth naturally should slow down, China s growth is still widely expected to outpace growth of developed markets for some time to come. However, it is important to note that strong growth of a country s gross domestic product (GDP) 1 does not necessarily lead to favorable investment returns. A growth story like China s is susceptible to lots of hype and attention. Amidst the excitement, less attention may be paid to how investment exposures are achieved. In short, we believe that China s equity market has the potential to provide compelling opportunities, but traditional market cap-weighted 2 approaches to Chinese equity indexes are currently susceptible to unique concentration risks, namely in Chinese financials. FINANCIALS: A DOMINANT SECTOR Figure 1: total market cap of the msci china financials sector index compared to the broader msci china index [ 6/30/2002 6/30/2012 ] 5 4 3 MSCI China Index MSCI Emerging Markets Index MSCI EAFE Index S&P 500 Index 2 6/30/02 6/30/03 6/30/04 6/30/05 6/30/06 6/30/07 6/30/08 6/30/09 6/30/10 6/30/11 6/30/12 Source: Bloomberg 1 Gross domestic product (GDP): The sum total of all goods and services produced across an economy. 2 Market cap-weighted: Market cap = (share prices) x (number of shares outstanding). Firms with the highest values receive the highest weights.
WisdomTree Research market insights [ September 2012 ] Figure 1 indicates the percentage of the market cap of each of the four specified indexes that has been in the financial sector over the 10-year period ended 6/30/2012. There is little question that the MSCI China Index stands out from about the end of the 2005 calendar year through the end of the period shown. A similar run-up in overall market capitalization of the financial sector as a percentage of the respective broader index s market cap was not seen in any of the other market capitalization-weighted indexes shown. This depiction illustrates the potential for a significant lack of diversification with a market cap-weighted index of China s equities. Looking back over history, we are reminded of the Japanese equity market bubble, where Japan received a dominant, approximately 6 weight in the MSCI EAFE Index in 1989, and then in 2000, when the information technology sector made up nearly 3 of the S&P 500 Index. The subsequent performance of these broad equity market indexes was dominated by the performance of these heavily weighted components a performance that was understandably lackluster after such rich valuations. OVer 53% in the financial sector Figure 2: ftse china 25 index sector weights [ As of 8/31/2012 ] 6 5 53.2% 4 3 2 22.1% 19.7% 0. 0.8% Discretionary Staples 0. 1.9% Energy Financials Health Care Industrials Information Technology 2.3% 0. 0. Materials Telecommunication Services Utilities Holdings subject to change. You cannot invest directly in an index. Sources: Bloomberg, S&P, WisdomTree Investments in strategies that are designed to track the FTSE China 25 Index may expose investors to unwanted concentration risk, as three sectors (Financials, Telecom and Energy) represent about 95% of the overall exposure. Financials command more than half the sector exposures. While it is true that individuals cannot invest directly in indexes, for illustrative purposes it is notable that over 53 cents of each hypothetical dollar tracking this index would be exposed to China s financial sector. The performance of the FTSE China 25 Index, whether viewed by the metric of either risk or return, is dominated by the performance of Chinese financials. Of course, at times this can be a positive, and at times this can be a negative, but we think that it is essential that anyone analyzing the performance of this index recognize that it is this dependent on the behavior of a single sector. 2
WisdomTree Research market insights [ September 2012 ] Significant Risk Historically for the MSCI China Financials Sector Index Figure 3 indicates that the average annual standard deviation 3 of the MSCI China Financials Sector Index for the last 10 years approaches 4, a high level of volatility that surpasses the broader MSCI China Index. An equal-weighted blend of the non-financial sector indexes in China, China ex-financials, had an average annual standard deviation of about 2 percentage points less than the MSCI China Index and 10 percentage points less than the MSCI China Financials Sector Index over the 10 years from June 30, 2002, through June 30, 2012. Figure 3: risk and return characteristics [ 6/30/2002 6/30/2012 ] 18% China ex-financials 16% 14% 12% MSCI Emerging Markets Index MSCI China Index MSCI China Financials Sector Index Return (%) 8% 6% 4% S&P 500 Index MSCI EAFE Index Index Return (%) Std. Dev. Sharpe Ratio MSCI China Financials Sector Index 13.36% 36.09% 0.32 China ex-financials 4 16.04% 26.08% 0.55 MSCI China Index 15.76% 28.5 0.49 MSCI Emerging Markets Index 14.42% 24.69% 0.51 MSCI EAFE Index 5.62% 19.18% 0.20 S&P 500 Index 5.33% 15.84% 0.23 2% 15% 2 25% 3 35% 4 Risk (%) Sources: Bloomberg, Zephyr StyleADVISOR Past performance is not indicative of future results. You cannot invest directly in an index. Index performance does not represent actual fund or portfolio performance. A fund or portfolio may differ significantly from the securities included in the index. Index performance assumes reinvestment of dividends but does not reflect any management fees, transaction costs or other expenses that would be incurred by a portfolio or fund, or brokerage commissions on transactions in fund shares. Such fees, expenses and commissions could reduce returns. 3 Average annual standard deviation: A measure of dispersion of a series of returns around an average over a specific period. Higher values indicate a higher chance of experiencing an observed value farther away from the specified average value. 4 Reflects an equal-weighted basket of the nine MSCI China Sector Indexes outside of financials, rebalanced annually. 3
If Financials Are Likely to Be Weak, Why Bother Investing in a Given Market? An initial reaction to any ex-financials equity approach might be to think that if the financial sector is weak, then the rest of the market is likely to also be weak. In that regard, the United States, through the use of the S&P 500 Index, presents an interesting case study over the past decade. We look to this index and country mainly because of the breadth of history available the financial crisis of 2008 09 was without question the worst since the Great Depression of the 1930s. China s equity markets do not have such a record of performance history from which to draw. Figure 4 indicates that over the past decade, in the face of such a severe crisis, there has been a decoupling between the performance of the broader S&P 500 Index and that of the S&P 500 Financials Sector Index. While we can t say that this will always be the case or that similar results would necessarily hold true for China s equities, we can say that it is possible for the performance of financials can to be markedly different from that of other sectors. + Most noteworthy is the average annual performance over the five years ended June 30, 2012, where even though the financials component was down by over 14% per year, the broader S&P 500 Index was pulled up enough by the other nine sectors to generate a positive return. The other nine sectors, in an equal-weighted blend, had over 3.3% average annual returns. + On a 10-year basis, while the financial sector was down nearly 3% per year, the other nine sectors averaged nearly 7.75% per year. Figure 3 makes it clear that the profile presented by the average annual volatility over the 10-year period ended June 30, 2012, indicates a contrast in average annual risk between the MSCI China Financials Sector Index and the broader MSCI China Index that of being about 8 percentage points riskier per year. This leads us to think that, while it isn t possible to say whether the results of the MSCI China Index will be similar to the case study in figure 4, it is already apparent that the MSCI China Financials Sector Index, by virtue of its higher average annual standard deviation, has the potential to exhibit significantly different returns than the MSCI China Index or an equal-weighted blend of the nine other MSCI China Sector Indexes. 4
a case study in u.s. equities: the impact of the financial crisis on returns Figure 4: average annual returns for 3, 5, and 10 years [ As of 6/30/2012 ] 25% 2 15% 16.4 18.04% S&P 500 Index S&P Financials Index S&P 500 ex-financials Blend 5 5% 8.67% 3.37% 5.33% 7.72% 0.22% -5% -2.95% - -15% -2-14.6 3 Year 5 Year 10 Year You cannot invest directly in an index. Index performance does not represent actual fund or portfolio performance. A fund or portfolio may differ significantly from the securities included in the index. Index performance assumes reinvestment of dividends but does not reflect any management fees, transaction costs or other expenses that would be incurred by a portfolio or fund, or brokerage commissions on transactions in fund shares. Such fees, expenses and commissions could reduce returns. Past performance is not indicative of future results. Sources: Bloomberg, Zephyr StyleADVISOR Alternative Index Weighting Strategies for China s Equities May Increase Diversification There are many ways to select and weight the underlying constituents of equity market indexes, and though the standard approach involves market cap-weighting, it is a mistake to assume that that is the only or best solution in every case. At WisdomTree, we have developed what we believe is a rather unique way to measure the performance of China s equity market while mitigating what we see as a large potential risk of traditionally market cap-weighted indexes of China s equities: sector concentration. Essentially, WisdomTree s China Dividend ex-financials Index aims to: + Exclude the financial sector: We believe the performance of Chinese equity market indexes should not be dependent on one sector in the type of concentrated way that results from more traditional market cap-weighted index methodologies. This Index can serve as a benchmark for Chinese stocks outside of the financial sector. + Companies are weighted in the Index based on annual cash dividends paid. Companies that pay higher dividends and meet specified liquidity 6 and other criteria generally have a higher weight in the Index. At the time of the Index s annual rebalance, the maximum weight of any security in the Index is capped at and the maximum weight of any one sector in the Index is capped at 25%. In response to market conditions, security weights may fluctuate above and sector weights may fluctuate above 25% between annual Index rebalance dates. 5 Reflects an equal-weighted basket of the nine S&P 500 Sector Indexes outside of financials, rebalanced annually. 6 Based on the average number of shares traded. 5
managing risk in china s equity markets: Diversification Figure 5: wisdomtree china dividend ex-financials index sector weights [ As of 8/31/2012 ] 3 25% 24.5% 2 15% 13.8% 13.2% 13.2% 14.8% 5% 5.8% 7.3% 6.5% Discretionary Staples 0. 0.9% Energy Financials Health Care Industrials Information Technology Materials Telecommunication Services Utilities Source: WisdomTree Holdings subject to change Figure 5 shows the result of WisdomTree s methodology with respect to sector weighting a very different picture than the market capitalization-weighted indexes shown in figure 2. Two additional points of interest: + The FTSE China 25 Index has further concentration risk within its top 10 holdings, which make up a total of approximately 62 percent of its weight 7. Clearly, these heavily weighted firms will have significant impact on the measured performance for the index. + The WisdomTree China Dividend ex-financials Index has about 44% of its weight in its top 10 holdings in other words, much lower concentration of these more heavily weighted firms and a contrast to the market capweighted index shown above. Given that China s equity markets can be subject to high levels of volatility in general, we think that index methodologies that increase potential diversification can help mitigate the risk of heavy concentration, either within industry sectors or individual companies. 7 Source: FTSE, as of 8/31/2012. 6
Conclusion China is one of the more important economic actors on the global stage, and as such its investment markets are expected to continue attracting significant attention. Anytime this occurs, it is important to take a step back, especially when considering the performance of equity market indexes. How constituents are selected and then weighted has a major influence on the performance that these indexes measure. Given that we imagine many investors may not want to take a sector bet resulting in 5 exposure in China s equities weighted directly in the financial sector, we think it makes sense to consider an alternative way of building an index for China s equities. Unless otherwise stated, data source is WisdomTree. Investors should carefully consider the investment objectives, risks, charges and expenses of the Funds before investing. To obtain a prospectus containing this and other important information, call 1.866.909.WISE (9473) or visit wisdomtree.com. Read the prospectus carefully before you invest. There are risks associated with investing including possible loss of principal. Foreign investing involves special risks, such as risk of loss from currency fluctuation or political or economic uncertainty. Fund s focusing investments on certain sectors increase their vulnerability to any single economic or regulatory development. This may result in greater share price volatility. Please read the Fund s prospectus for specific details regarding the Fund s risk profile. MSCI China Financials Sector Index: A free float-weighted equity index designed to measure the performance of the Chinese financial sector of the country s equity market. MSCI China Index: A free float-weighted equity index designed to measure the performance of the Chinese equity market. FTSE China 25 Index: Represents the 25 largest and most liquid Chinese stocks (H Shares and Red Chips) listed and trading on the Hong Kong Stock Exchange. MSCI Emerging Markets Index: Broad market cap-weighted index showing performance of equities across 21 emerging market countries, defined as emerging markets by MSCI. MSCI EAFE Index: Market cap-weighted index composed of companies representative of the developed market structure of 21 developed countries in Europe, Australasia and Japan. S&P 500 Index: Market capitalization-weighted benchmark of 500 stocks selected by the Standard and Poor s Index Committee, designed to represent the performance of the leading industries in the United States economy. WisdomTree Funds are distributed by ALPS Distributors, Inc. Jeremy Schwartz, Christopher Gannatti and Chris Jabara are registered representatives of ALPS Distributors, Inc. 2012 WisdomTree Investments, Inc. WisdomTree is a registered mark of WisdomTree Investments, Inc. WIS004411 9/2013 7