Our Investment Committee has talked about China weekly for several months now. Over that time, the news about a possible war has been building. China may try to seize Taiwan or may not. The United States may go to war with China or may not. It may be a big deal or it might be nothing.

This article is about our response to this possibility. For more context about this topic, read our article “Executive Summary of the Possible Taiwan Conflict.”

In response to this news, most investment advisors have had one of two reactions. In true Marotta fashion, we have had both reactions and elected to make half a mistake.

Reaction 1: There is no way to quantify geopolitical risk.

The best example of this reaction is John Pearce, an Australian chief investment officer. In the April 27, 2023 Reuters article , Pearce is quoted as saying:

We’re positive on China over the short term but our long term outlook is neutral to negative. As it’s impossible to quantify geopolitical risks we don’t attempt to. Our reservations about China’s long-term investment prospects are based on our outlook for returns to capital.

Investment managers use profitability numbers to calculate a stock’s perceived value. However, many risks cannot be considered in profitability metrics.

You can make more money with a more profitable company. But what if that company’s country goes to war? What will happen to the stock returns? No one knows.

The risk of war cannot be quantified. The effects of war on a stock cannot be accurately described or predicted. We cannot even measure the likelihood that there will be a war.

It is too hard to factor in geopolitical risk. This is why some investors have decided they may as well not try.

This reaction would suggest continuing investing per usual. If fundamentals suggest weakening performance, then you move away from those holdings. If fundamentals remain strong, then you stay the course.

Reaction 2: If I can get the same return for less risk that is more efficient.

The best example of this reaction is Warren Buffet, the famous investor CEO behind Berkshire Hathaway. In February of 2023, Buffet divested from 86% of his shares in Taiwan Semiconductor. Then, at the May 2023 Berkshire Hathaway annual meeting, Warren Buffet is quoted as saying :

Taiwan Semiconductor is one of the best-managed companies and important companies in the world. I don’t like its location and reevaluated that, … [but] there’s no one in the chip industry that’s in their league, at least in my view.

He went on to explain that the reason for the sale is only its geographic location. The “rising geopolitical tensions between China and Taiwan as well as China and the US” led to the sale.

This viewpoint focuses more on the efficient frontier. To be on the efficient frontier, a portfolio needs to have the highest expected return for its expected risk.

Because of the possibility of investment controls, an investment in China now carries a lot more risk. To remain efficient, its expected return needs to be higher than before. But nothing has happened in China’s fundamentals to suspect a higher return. So, the extra potential for risk might make the portfolio inefficient.

You can increase the chance of having an efficient portfolio by reducing the geopolitical risk.

Half a mistake.

During the war on Ukraine, the United States banned Americans from buying Russian stocks and bonds . If this conflict escalates, the U.S. might put similar investment controls on Chinese investments. These investment controls make the affected holdings effectively worthless to U.S. investors.

In February 2022 right before the investment controls, Russia was 3.19% of the FTSE Emerging Markets Index. When 3.19% of the index could only be sold below fair market value to foreign investors, it hurt emerging market returns.

As of April 30, 2023, China represented 34% of Vanguard FTSE Emerging Markets ETF (VWO). Investment controls on China would devastate emerging market returns.

China has had poor performance recently, but its economy is very large. One in every five people in the world lives in communist China. Thanks to China’s historical growth, its economy has been projected to pass the U.S. economy at some point . But recently, China’s population has been shrinking , leading to more bearish projections.

As we have written about previously, we don’t recommend selecting Chinese investments for specific emphasis. It is a component of the Emerging Market Index (which deserves a small place in your portfolio), but we don’t recommend adding any additional overweight to China.

Now that China’s long-term outlook is more negative and it carries outsized geopolitical risk, we have elected to reduce our allocation to Vanguard FTSE Emerging Markets ETF (VWO) and add Columbia EM Core ex-China ETF (XCEM). XCEM is a cap-weighted emerging markets fund which excludes investment to China and Hong Kong. In the prospectus, the fund managers have stated that they will use their discretion to define the definition of “emerging market” for inclusion in the fund.

Currently, their prospectus defines EM this way:

Subject to periodic review and change, Columbia Management currently classifies the following countries as emerging markets: Brazil, Chile, Colombia, Czech Republic, Hungary, India, Indonesia, Kuwait, Malaysia, Mexico, Pakistan, Peru, Philippines, Poland, Russia, South Africa, South Korea, Taiwan, Thailand and Turkey.

Compared to the FTSE which VWO follows, the differences are that XCEM includes Peru, Poland, and South Korea and excludes Egypt, Greece, Iceland, Qatar, Romania, Saudi Arabia, United Arab Emirates, and of course China.

Because XCEM has allocations to our individual Freedom Investing emerging market countries of South Korea, Taiwan, and Chile, we have also reduced our allocations to those country-specific ETFs to keep their overweight relatively the same.

Effectively, this means that we have increased the allocation to most other EM countries while decreasing our allocation to China by approximately 25%. This half a mistake (or perhaps half of half a mistake) is a good beginning to prepare portfolios for possible war.

If China booms, it may be a mistake that we reduced the allocation. If China undergoes investment controls, it may be a mistake that we kept China at all.

As always, our investment committee will continue to monitor the situation.

Photo of China by Benjamin Patin on Unsplash. Image has been cropped.