By Claire Milhench
LONDON (Reuters) - China is heading for such dominance in the world's main emerging market stock index that investors are scrambling for ways to water down the too-many-eggs-in-one-basket risk.
Among the options on offer are standalone China-dedicated funds and even trying to move further away from investment benchmarks themselves.
China - increasingly dominant in all spheres of economic and politics - currently accounts for around 24 percent of MSCI's emerging market stock index <.MSCIEF>, which is tracked in one way or another by around $1.6 trillion in investments.
This means that a losing day in Shanghai can mean a losing day for emerging market investors as a whole. But the impact is expected to balloon in coming years when almost 400 mainland China-listed stocks - known as A-shares - are added.
That will take China's weight up to more than 40 percent.
It is already starting to grow. On Thursday, MSCI will announce the inclusion of around 14 U.S.-listed Chinese companies such as web giants Alibaba
That will boost China's share in the index to around 25.6 percent, according to estimates by HSBC analyst Vijay Sumon, whilst Korea, Taiwan and Brazil could see their weightings fall by about 21-43 basis points each.
This, however, is small potatoes compared with the changes expected when A-shares meet the criteria for inclusion - not just for so-called passive investors who simply track the index but also for active managers who move their allocations within the general bounds of the index.
The latter - whose holdings comprise some $1.3 trillion of the total - face restrictions on how much of their portfolio can deviate from the index.
"They have to be very careful they don't stray from the benchmarks as measured by the tracking error," said Nitin Dialdas, chief investment officer at Mandarin Capital in Hong Kong. Tracking error measures how closely a fund follows the index to which it is benchmarked.
"A 15-20 basis points tracking error for the large guys is probably acceptable, more than 50 basis points is probably pushing it," Dialdas added.
If a country is no more than 10 percent of the index, this constraint isn't a problem, but once China swells to over 40 percent of the index, investors buying a global EM fund will have a significant exposure to a single market.
"Country risk is the biggest source of risk for an emerging markets investor, and the nature of benchmarks often leads to an over-concentration of country risk which would make many investors uncomfortable," said Mathieu Negre, head of emerging market equities at UBP.
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In an attempt to overcome this, UBP is converting an existing fund into a new structure that will decide its own country weightings using top-down macro research.
"Structurally it will be underweight the biggest countries and overweight the smallest countries. Over time this should deliver lower volatility versus the benchmark, thanks to better diversification," Negre said.
Others, such as William Palmer, co-manager of Barings' Global Emerging Markets fund, take a "benchmark agnostic" view. This means he doesn't feel compelled or obliged to invest in any company or country just because it is in the index.
Instead, a third of his fund is "off-benchmark" meaning he just selects the stocks he likes, cutting some country exposures to zero or buying companies not included in the index.
Some investors, including Palmer, are not waiting for A-shares to enter EM indexes, despite a rollercoaster ride on mainland Chinese stocks this year. The index <.CSI300> slumped more than 30 percent in less than a month from mid-June, after rising 50 percent in the first half of 2015.
Gerardo Rodriguez, head of multi-asset emerging markets at BlackRock, reckons China may be a different category altogether, given that it accounts for 40 percent of emerging markets economic output.
He wonders whether investors will continue to think of China, with its huge global clout, in the context of emerging markets: "The idea of clustering China with other economies may be hard given it's such a big and idiosyncratic market."
Instead, it may make more sense to treat it as a standalone market and invest via dedicated funds.
"We are already seeing a bit of that, with people having an Asia fund and then supplementing that with a specialist China or India fund," said Robert Horrocks, chief investment officer of Matthews Asia.
According to Lipper data this universe is growing, with some 14 pan-European regulated China equity mutual funds launched over the last 12 months, taking the universe to 71 in total.
(Additional reporting by Sujata Rao in London and Saikat Chatterjee in Hong Kong Editing by Jeremy Gaunt)
