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The Greek Debt Crisis & the Chinese Stock Market Sell-Off

Summer 2015

Events in Greece and China have been the overwhelming focus of investors worldwide in recent weeks. You may be wondering how the Greek crisis and suspension of trading in China will affect your portfolio and long-term investment objectives. Below is some background and insight about each country.

 

The Greek Debt Crisis

Greece faces a number of challenges on an economic and political front. The Greek government closed Greek banks for three weeks and has introduced capital controls. Greece is a very small country by market capitalization and, therefore, generally makes up a relatively insignificant portion of holdings in our emerging market allocation. The weighting of Greece accounted for 0.37% of our emerging market portfolio, as of May 31, 2015.

Capital Controls and Market Closures

The introduction of capital controls and market closures in Greece is not unprecedented. Iceland and Cyprus have implemented capital controls, with Cyprus recently lifting controls and Iceland announcing plans to lift restrictions. Egypt closed its stock exchange in 2011 as a result of heightened political risk.

Possible Exit from the Eurozone

Mutual fund Dimensional Fund Advisors have had their Investment Committee and the Portfolio Management and Trading teams monitoring the situation in Greece for a significant period of time. They are in consultation with relevant industry sources, including custodians, brokers, and middle office providers, regarding trading conditions in Greece and their contingency plans, should any change in currency occur. The fund’s portfolio management and trading systems are designed to be adaptable. We are extremely confident those systems can accommodate any change in currency should one be announced.

Dimensional’s investment approach allows the investment team flexibility to assess the current environment to evaluate any operational concerns for the funds or accounts. Index providers such as MSCI, FTSE, and Russell have stated that they, too, are monitoring the events in Greece, but to date, have not announced any specific changes to indices.

The PIMCO Total Return fund has a 0.2% exposure to Greek debt. Many of our clients who hold bonds do so in their taxable portfolio and thus hold muni bonds, which have no exposure to Greece.

 

The Chinese Stock Market Sell-Off

Our allocation to emerging market countries includes investment in Chinese companies via shares that trade on exchanges outside of China, primarily in Hong Kong. Eligible securities include H-shares and red chip stocks that are traded in Hong Kong, American depository receipts (ADRs) that trade in the U.S., and global depository receipts (GDRs) trading on approved exchanges in other approved markets. Recent trading suspensions of stocks in Chinese companies and corresponding government interventions have generally been for Chinese A-shares that trade in mainland China on the Shanghai and Shenzhen exchanges.

In China, companies can request that their shares be suspended from trading for one of three reasons: restructuring, new share placement, or any other material new information. In the recent market downturn, companies have been using the third, more subjective, criterion to request suspension of their shares. As of July 9, 2015, approximately 1,300 companies (close to 50% of all stocks on those exchanges) were suspended from trading across the Shanghai and Shenzhen exchanges. By comparison, suspensions of Chinese companies trading in Hong Kong are fewer, and many appear to be longer standing and for reasons of restructuring or new share placement. We are currently evaluating the impact of recent suspensions on our portfolios. At this time, it appears that the impact is minor, given our approach to investing in China outside of the local Chinese exchanges.

Our emerging markets strategy via the Dimensional Emerging Markets Core Equity Portfolio caps the holding in any one country at 15%. As of the end of June, the fund’s China exposure had a weight of 16.7% versus 25.2% in the MSCI Emerging Markets Index. On the bond side, none of our Dimensional funds own Chinese debt. Clients who hold PIMCO Total Return have 1.6% of that holding in China.

Investing in China: Foreign Markets (H-Shares) vs. Local Market (A-Shares)

The Chinese equity market is segmented into two broad classes of shares: 1) H-shares are available for unlimited foreign investment, and 2) China A-shares with restricted access to foreign investors.

H-shares primarily consist of shares of firms incorporated in or controlled by entities in Mainland China but which trade outside of China, generally on the Hong Kong exchange in HK dollars. These stocks trade like any other stock on the Hong Kong exchange (a developed market exchange), and are the class of shares currently included in Dimensional’s emerging markets strategies, as well as most commercial benchmarks for emerging markets.

Chinese A-shares trade exclusively in Mainland China on the Shanghai and Shenzhen exchanges in Chinese Yuan (CNY). Historically, the access of foreign investors to these shares has been restricted. One of the main forms of access has been the Qualified Foreign Institutional Investor (QFII) program, wherein foreign institutional investors can apply to receive an allocation to invest in the A-share market. If an allocation is granted, there are significant restrictions, including repatriation of capital. These restrictions have made holding A-shares less appropriate for open-ended mutual funds.
 
Composition Differences

There are differences in the composition (such as companies, sectors, and size distribution) of H-shares versus A-shares. Of the approximately 100 companies that had both A- and H-share listings as of March 31, 2015, these firms represented just 30% of the total investable capitalization of firms with A-share listings. Thus, 70% of the market capitalization of A-shares is not accessible through H-shares. These differences in composition between H-shares and A-shares imply changing market access and structure will lead to differences in the performance between H- versus A-shares.

The historical performance of A-shares and H-shares has not moved in lockstep. For example, in 2003, the MSCI China Standard Index (H-shares) returned 87.6% versus 5.1% for the MSCI China A Standard Index. In 2014, the MSCI China Standard Index returned 8.3% versus 46.9% for the MSCI China A Standard Index. In 6 of the 14 years since 2001, there has been greater than a 20% return difference between H-shares and A-shares (as measured by the MSCI Indices).

The Dimensional Emerging Market Core fund continues to closely monitor the developments on the mechanisms to access the A-share market and assess the suitability of such investments for open-ended mutual fund investments. The expected benefits of including such shares would be greater diversification.

 

In Conclusion

Events in Greece and China remain fluid, and the investment committee for the Dimensional emerging market fund is actively monitoring developments.

We continue to emphasize the importance of broad diversification within and across asset classes as a consistent way to pursue the expected return premiums associated with different asset classes. As a result of our diversified approach to equity investing, exposure to any single Greek or Chinese stock is very limited, as is the overall exposure to each country.

Like you, we do not know what the future holds. Capital markets incorporate all known information and associated expectations, and the widespread anxiety is already reflected in prices. Our disciplined investment processes, the flexibility of our approach, and the quality of our investment team position us well to continue to manage portfolios in the best interests of our clients.

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