Emerging market investing has never been a one-size-fits-all approach, and China’s sheer size and role has only added to the complexity. As the world’s second-largest economy and a major part of emerging market (EM) indices, China presents both opportunities and challenges. Geopolitical tensions, regulatory shifts, and market access concerns have led some investors, including Finnish pension insurer Veritas, to rethink their approach. Rather than eliminating China exposure entirely, Veritas has embraced “Ex-China” allocations to gain broad EM exposure while maintaining flexibility to allocate to China separately.
The Case for a Separate China Allocation
As a proponent of active management in emerging market equities, Veritas had traditionally relied on fund managers employing an “all-markets” approach. However, starting last year, the team initiated a comprehensive overhaul of its EM portfolio, shifting half of its allocation to “Ex-China” emerging market managers while appointing dedicated China specialists for the remainder. “We saw the need for greater control over our China exposure,” explains Portfolio Manager Tapio Koivu, citing several factors behind the decision.
One key reason for the shift was the varying perspectives and approaches that “all-market” managers took toward China. “Each manager comes with distinct biases and views on China—some prefer to avoid it entirely, while others maintain more significant exposure,” explains Koivu. By separating emerging market allocations into dedicated China-focused and Ex-China mandates, Koivu and his team seek to achieve greater control and flexibility in managing their China exposure.
“We recognize that emerging markets are not a single, uniform story, but China stands apart in many ways, including its demographics. We saw the need for greater control over our China exposure.”
Another important factor behind the decision to separate China from the broader emerging markets allocation was the fundamental differences between China and other EM economies. “We recognize that emerging markets are not a single, uniform story, but China stands apart in many ways, including its demographics,” says Koivu. In many respects, China resembles a developed market, with a highly sophisticated economy, deep capital markets, and globally dominant industries. However, its political and regulatory environment remains distinct, with state intervention playing a far greater role than in traditional developed markets.
Addressing Geopolitical Risks and Opportunities
“Initially, the discussion focused on China’s sheer size – its weight alone justified a dedicated allocation,” Koivu explains. However, the unique political landscape and the broader implications of China’s relationship with the United States ultimately became the deciding factor in Veritas’ decision to separate its China and Ex-China emerging market exposures. “China holds a substantial weight in EM indices and remains a key driver of overall performance. If you simply follow the index, you’re inherently taking on substantial exposure,” Koivu notes.
The team at Veritas evaluated multiple scenarios, including more adverse outcomes where escalating geopolitical tensions could lead to China’s isolation. “In such a case, the impact on the emerging market allocation could be devastating,” argues Koivu. Rising tensions between China and the West – particularly with the U.S. – have already resulted in trade restrictions and fears of forced divestments. “For that specific downside scenario, it’s important to have the flexibility to manage and reduce exposure quickly,” Koivu emphasizes. “It’s not our base case, but it’s a risk we need to account for.”
“Having this flexibility is an advantage – it gives us an additional lever in our toolkit to fine-tune our exposure as market conditions evolve.”
The potential for a positive scenario also reinforced the decision to separate China from the broader EM exposure. “The opposite case is equally valid,” Koivu explains. “China is currently trading at very low valuations and, on a broader scale, appears somewhat out of favor. If conditions improve, it could present significant opportunities,” he continues. “In such a scenario, we would want the flexibility to quickly overweight China – even substantially.” Ultimately, multiple factors pointed to the same conclusion: having greater control over China’s allocation and treating it separately within the portfolio was the right approach.
This adjustment, however, comes with its own challenges. “It’s not an easy shift because it requires us to take a more active role in determining our stance on China versus the rest of emerging markets,” Koivu admits. “Previously, we could rely on managers to make those calls, without needing to worry too much.” However, he sees this increased involvement as a net positive. “Having this flexibility is an advantage – it gives us an additional lever in our toolkit to fine-tune our exposure as market conditions evolve.”
The Benefits of Active Management in Emerging Markets
Over the years, Veritas has developed a diverse and region-specific strategy for investing in global equities. The firm employs a direct, fundamental approach for Finnish equities, a quantitative strategy for European equities, a predominantly passive approach for U.S. markets, and primarily relying on external managers for emerging market equities. “This is where active management can truly add value, in our opinion, which is not the case all across the globe,” he emphasizes.
“In U.S. large-cap equities, a passive approach makes a lot of sense,” Koivu argues. “However, in emerging markets, the environment is still quite inefficient. Active managers can add significant value here, helping to avoid pitfalls related to companies with poor governance or weak ESG profiles.” For more tactical allocations in emerging markets, Veritas may also turn to passive ETFs. “While the active funds we rely on are mostly daily liquid and not illiquid in that sense, our philosophy is to avoid interfering with active managers through inflows and outflows,” Koivu notes. “For more tactical trades, we prefer instruments like ETFs that are better suited for that purpose.”
“However, in emerging markets, the environment is still quite inefficient. Active managers can add significant value here, helping to avoid pitfalls related to companies with poor governance or weak ESG profiles.”
When selecting managers for emerging market investments, Veritas primarily favors discretionary stock pickers who adopt a “boots on the ground” approach. “I wouldn’t say there’s only one right way to approach EM investments – there are multiple successful approaches,” Koivu notes. However, the majority of Veritas’ managers tend to have strong analytical skills and a hands-on mentality, actively meeting with companies to gain a deeper understanding of the drivers and risks. Ultimately, Veritas prioritizes managers who follow a well-defined process and have the resources to execute it consistently, ensuring that their success is repeatable and not just the result of luck.
Emerging Markets as an Element of Portfolio Diversification
Veritas maintains a broad and diversified portfolio, with emerging markets being a natural component due to their place in the global economy. Koivu highlights that the allocation to emerging market equities is valuable for diversification, as many of the drivers in these markets differ from those in developed markets. While the past decade has been challenging for emerging markets in aggregate, Koivu remains optimistic. “In the long term, the underlying drivers are still there, and the region offers a diverse mix of countries and companies,” he notes. With a more active approach, he believes there are significant opportunities, even during periods of market uncertainty. “Before this prolonged downturn, emerging markets experienced a significant boom, and there’s no reason why that couldn’t happen again in the future.”
