As China changes, consumer exposure, index caution are key

China's rebalancing toward consumption may be the dominant influence in emerging markets investment in coming years.

Sticking close to the index could be painful.

Not only will China's transition away from an economy with an export and investment monoculture toward one with more balance have huge influence there, but it will also drive returns across ­emerging markets.

This transition, both inside and outside China, promises long-term rewards but may include substantial pain if you don't get out in front of the changes.

Growth in China is slowing rapidly, an inevitable side-effect of moving away from massive amounts of fixed investment toward domestic consumption. While China reported annualized third-quarter growth of 6.9 percent, economists at Goldman Sachs recently added their voice to the growing number saying that figure is about 5 percent a year.

China's growth story has been remarkable and has shaped not just the global economy, but heavily influenced development in emerging markets, giving a boost to those countries that did well in producing the inputs to Chinese investment or those that did well integrating themselves into China's manufacturing supply and distribution chain.

That has shaped the emerging market indexes into which investors can place money, or against which money managers make their allocation decisions.

"That means that any diversified emerging market or developed market investment products (mutual funds or ETFs) that look anything like the benchmark are by default leaning into the wind rather than letting it push them," Bryce Coward of Gavekal Capital wrote in a note to clients.

"Putting it all together, the following, in our opinion, is the single most important thing investors should be thinking about as they consider core allocations to developed and emerging markets:

"Do the products I'm invested in or considering look like the benchmark or do they look different from an allocation perspective? It goes without saying that products that are allocated like the benchmark will perform like the benchmark and investors need to decide if that situation is optimal, or not. In our opinion, the answer is clearly, 'No.' "

In other words, if a company makes its living selling the things, raw materials or otherwise, that China needs to build roads, factories and buildings, it faces a tougher time. If, however, you are exposed to China's growing consumer economy, you will see, if not capture, a growing market.

Health companies and consumer companies: good; energy, financial, industrial and materials: not so good.

"Consider Consumer Discretionary — a sector some investors might associate with consumption by a growing middle class. Its weighting is notably lower in S&P's Emerging Markets index than in S&P's Developed Market index. Instead, the S&P Emerging Market index has higher weightings for Financials, Materials, and Telecom Services," according to the study.

So financials in emerging markets, many of which are extremely large capitalization, are crowding out the exposure that investors might otherwise have to sectors that, inside of China and out, have better prospects.

It is also true that capitalization-weighted indexes often end up with very large exposure to the largest companies, some of which, particularly in China, are state-run and thus less likely to be focused on ­maximizing profits.

China may end up being the locus of two extremely powerful and rare economic developments over the past 30 years and the coming 10: first, its rise as an exporter and integration into the global economy, and second, its transformation into something closer to a consumer economy. While the force of this will be felt everywhere, it will have more effect in emerging markets, especially those integrated with China.

Economic turning points create great wealth while destroying a smaller amount of businesses and livelihoods. They also pose a real, if rare, risk to index investors, who theoretically may see their returns lag overall growth during such transformations.

Now, in emerging markets, may prove to be a time when indexing, at least in standard forms, is a mistake.