Proposed SEC rule for protecting consumers from emerging market ETF reallocation

Economy 0 comments

            In November 2019, exchange-traded fund (ETF) index-providers began allocating between 33% and 37% of their emerging market funds to Chinese companies, resulting in more than $400 million flowing into the country.[1] The trend is on track to continue: US portfolio investment in the Chinese market could increase to more than US $1 trillion by the end of 2021.[2] This exposes investors to political and financial risk that they are not aware of, and which companies are not incentivized to actively inform them of. The solution is to implement SEC regulations that focus on improving transparency for the individual investors that increasingly make up the ETF market.

            This type of reallocation increases political risk because economic policy in both the US and China is trending toward economic decoupling. This is not likely to change in the short term. On the US side, competition with China has bipartisan support, and 60% of the population holds a negative view of the Chinese government.[3] On the Chinese, “Made in China 2025” and the dramatic decrease in Chinese foreign direct investment in the US—from $60 billion in 2016[4] to only $5.5 billion in 2019[5]—make clear the intention to decouple. Finally, it took over 1.5 years to arrive at the Phase One trade deal, and observers have commented that it does not demonstrate a commitment to improving long-term relations.[6] By investing so heavily in China, index-providers are not only counteracting US economic policy, but are increasing the extent to which investors’ portfolios would be impacted if the US-China relationship continues to deteriorate.

            Meanwhile, allocating such a large proportion of investments to a single market increases rather than mitigates financial risk, which runs counter to the purpose of investing in an index. Emerging market ETFs distribute risk by investing in several developing economies at once. For example, MSCI advertises their index as covering 26 markets,[7] and Vanguard’s overview page touts investments in several BRICS countries.[8] In reality, however, the November 2019 change means 33% of MSCI and 37% of Vanguard funds are invested in China—and these numbers rise even further, to 44%[9] and a whopping 51%,[10] respectively, when investments in Taiwan are included (relevant for risk assessment purposes because Taiwan’s trade with China exceeds its trade with the US, Japan, and South Korea combined).[11] This means that investors who purchased these ETFs did so expecting a diversified portfolio, but instead inadvertently committed half their funds to a single market.

            It would be reasonable to think that index-providers make allocation changes to maximize long-term growth, but that is not what motivates them. The SEC clarifies that ETF investment advisors owe a fiduciary duty to the fund, not to its shareholders.[12] This means that the goal is to increase assets under management, and therefore generate revenue—not to maximize long term growth for investors.[13]

            Current ETF transparency rules are written in such a way that protects institutional traders.[14] Instead, the SEC must impose active reporting requirements on index-providers so that individual investors—who are leading the charge in ETF adoption—are protected. An ideal way to do this would be to require annual notification of portfolio changes in a brief, one-page publication that highlights any change greater than 10% and any investment greater than 20%. This would be far more effective than an annual prospectus in allowing individual investors to perceive shifts in the fund’s composition over time. Instead of requiring investors to download a long PDF file and search for a needle in a haystack, this would allow those who disagree with the reallocations sell their holdings after a quick glance, thereby absolving index-providers of potential issues concerning insufficient informed consent as to political and financial risk.

[1] Foreign Policy, “Americans Are Investing More in China—and They Don’t Even Know It,”

[2] [2] Foreign Policy, “Americans Are Investing More in China—and They Don’t Even Know It,”

[3] Pew Research Center, “People around the globe are divided in their opinions of China,”

[4] Rhodium Group, “Two-Way Street: 2019 Update US-China Direct Investment Trends,”

[5] Xinhua, “Chinese investments in North America, Europe hit 9-year low in 2019: report,”

[6] Business Insider, “Trump’s trade deal with China looks designed to implode,”

[7] MSCI, “MSCI Emerging Markets Index,”

[8] Vanguard, “Vanguard FTSE Emerging Markets ETF,”

[9] MSCI, “MSCI Emerging Markets Index,”

[10] Vanguard, “Vanguard FTSE Emerging Markets ETF,”

[11] World’s Top Exports, “Taiwan’s Top Trading Partners,”

[12] SEC, “Statement at Open Meeting on Exchange-Traded Funds,”

[13] Investopedia, “ETF Profits: How Much Money Are Providers Making?”

[14] SEC, “Exchange Traded Funds: Final Rule,”, pp. 70-78

Author Nicholas Andonie