New Bill Would Ban Chinese Stocks in Index Funds

The measure is part of a package that would both tax Chinese dividends at higher rates and require more disclosure for securities with exposure to China.

Representatives Brad Sherman, D-California, and Victoria Spartz, R-Indiana, introduced four bills that would restrict or disincentivize U.S. investors from investing in China. The bills were referred to the U.S. House Committee on Financial Services on March 20.

The No China in Index Funds Act would forbid funds that track an index from holding any Chinese securities starting 180 days after the bill is passed. Sherman’s office explained that passively managed index funds do not exercise the same due diligence in asset selection or monitoring as do active funds and therefore do not carefully examine the unique risks of Chinese companies.

As such, the bill does not affect actively managed funds. The bill also makes no distinction between an index fund that tracks an index that specializes in Chinese securities and an index fund that merely contains Chinese securities. This is an important distinction because index funds are only required to match 80% of an index in order to be considered an index fund, per the Securities and Exchange Commission’s requirements.

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As an example of how broadly such a ban would apply, the MSCI All Country World Index is a global equity index that measures the equity performance in 23 developed markets and 24 emerging markets. According to information from MSCI, the index included nearly 3,000 companies and covers approximately 85% of the global investable equity opportunity set, as of February. In the MSCI ACWI Index, excluding U.S. investments, (a version of the index), Chinese companies accounted for 7.12% of the index weighting as of last month. There were nearly 90 funds in the U.S. that used that fund as their benchmark, according to February data from Simfund, which, like CIO, is owned by ISS STOXX.

Another bill in the package, the No Capital Gains Allowance for American Adversaries Act, would subject income derived from securities in “countries of concern” to income tax, rather than to capital gains. “Countries of concern” are defined in the legislation as Belarus, China, Iran, North Korea and Russia.

A spokesperson for Sherman’s office clarified that in the case of pooled investment vehicles, such as mutual funds, the manager must track what proportion of the fund is from a “country of concern,” and only growth attributable to those holdings would be taxed as income. For example, a mutual fund with 40% exposure to China and 60% exposure to countries that are not “countries of concern” would have 40% of its gains taxed as income and 60% taxed as capital gains when a distribution is made.

The spokesperson also clarified that the bill would not affect the tax status of retirement plans or other tax-advantaged accounts.

The China Risk Reporting Act, another in the package, would require public companies in the U.S. to disclose the material risks that come from their supply chain’s reliance on China, and this would have to include a narrative disclosure of the company’s actions to minimize the risk. Sources of potential China risk identified in the bill include: rule of law issues in China, biased judicial proceedings, intellectual property theft and conflict between the U.S. and China.

Lastly, the PRC Military and Human Rights Capital Markets Sanctions Act would require the president to make a list of covered entities within 90 days of the bill’s passage. U.S. investors would be forbidden from trading in securities offered by those entities and would have to divest any of those securities. The list would include entities on the Specifically Designated National and Blocked Persons List, the non-SDN Chinese Military-Industrial Complex Companies List and other Chinese military companies.

The sanctions bill carries a 20-year maximum sentence for any U.S. investor “who willfully violates, willfully attempts to violate, willfully conspires to violate, or aids or abets in the commission of a violation of this Act.” It is the only one of the four to carry a criminal penalty.

H.K. Park, a managing director at Crumpton Global, a risk advisory firm based in Washington, D.C., says the volume of bills related to Chinese investment makes it difficult for investors to prepare for compliance because they often carry “different approaches and definitions. As a result, some GPs have asked us to conduct ‘national security assessments’ of all future target companies with Chinese or Russian links, inside and outside those two countries.”

Park adds that even the potential of successful legislation concerns investors, and “some LPs have asked us to conduct national security assessments of their current portfolio so that they can apply a hedging strategy for companies that might decline in value due to future geopolitical actions—for example, ByteDance—due to the proposed forced sale of Tik-Tok.”

The American Securities Association strongly endorsed the package of bills. Chris Iacovella, the ASA’s president and CEO, said in a statement that “prohibiting Chinese stocks from being included in index funds will protect American investors and prevent the Chinese Communist Party from using American capital to fund its military technologies, indiscriminate climate destruction, and gross human rights violations.”

Tags: China, index funds

The Chartered Alternative Investment Association, in partnership with several asset owners—all based outside the U.S.—is endorsing a new approach to institutional investing that eschews asset class benchmarks in favor of total portfolio outcomes, a tact proponents say could take a generation of change to implement.

The group this week presented a paper on the Total Portfolio Approach, written in collaboration with Australia’s Future Fund, Canada’s Canada Pension Plan Investment Board, the New Zealand Superannuation Fund and GIC, Singapore’s sovereign wealth fund.

The TPA strategy relies on the CIO, with support from the organization’s board, to set asset allocation using investment-team focused processes, which CAIA President John Bowman says could make it a difficult strategy for public pension funds to implement.

The TPA measures success based on total fund returns, rather than relative value in relation to benchmarks, and uses factors to achieve diversification, rather than asset classes.

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The report, “Innovation Unleashed—The Rise of Total Portfolio Approach,” was released by CAIA at the AltsLA Conference March 18-20 in Los Angeles.

The approach is presented as the “next realm” of portfolio construction, succeeding the Yale, Canadian and Norwegian models, which are versions of traditional strategic asset allocation, centered on fixed-target asset allocations.

Principles of Total Portfolio Approach

The Total Portfolio Approach is “one unified means of assessing risk and return of the whole portfolio,” wrote Geoffrey Rubin, a senior managing director and chief investment strategist with CPP Investments in the CAIA report.

It does not have specific guidelines that an investor must follow; rather, it is a “state of mind, rather than a policy or process,” according to Charles Hyde, head of asset allocation of the New Zealand Superannuation Fund, in the CAIA report.

Performance of a fund using the TPA should be measured based on total return against fund goals, instead of benchmarks, according to a report by WTW’s Thinking Ahead Institute. Success opportunities for investment are defined by contribution to the total portfolio outcome, rather than particular asset classes. Diversification is principally done via risk factors, rather than asset classes.

TPA does not merely view asset classes through broad labels such as “equities” or “real estate,” wrote Rubin and Derek Walker, managing director and head of portfolio design and construction at CPP Investments.

“Armed with this understanding, we can more accurately achieve our preferred mix of factor exposures designed to maximize returns at our targeted market risk level,” the two wrote.

The portfolio strategy is implemented by one team collaborating, rather than by multiple, asset-class teams competing for capital. By doing so, an allocator’s investment team can be nimble and make “meaningful changes to a portfolio in shorter periods of time,” according to Steven Novakovic, managing director of curriculum, and Christie Hamilton, director of content and research, both at CAIA.

WTW’s report emphasized that asset owners can vary in how much emphasis they put on different attributes that make up TPA.

Governance, Culture and Competition for Capital

In the report laying out the Total Portfolio Approach, CAIA noted it is not as “prescriptive”—meaning it does not abide by strict rules—as other investment models like the Endowment, Norway and Maple models.

CAIA identified four common practices of TPA already exhibited by the investors that contributed to the report. These have powerful CIOs unencumbered by rigid rules and outside pressures; invest through a factor lens; pick only the best assets; and possess a single portfolio culture, instead of a cluster of competing groups.

Governance and Flexibility: Australia’s Future Fund practices what it calls a “joined-up-whole-portfolio approach.” This means it has an empowered CIO office and no asset allocation targets, which enables the fund to “discuss the state of the world and competing opportunities without the constraint of labels or buckets,” wrote Ben Samild, the Future Fund’s CIO, in the CAIA report.

Factors: Rubin and Walker, of CPP, endorse a “factor lens” approach when categorizing asset classes and when understanding the drivers and risk and return of a diversified portfolio. “The foundation of a multi-factor lens begins with setting an appropriate market risk appetite before allocating that risk across exposures that they believe will yield the best risk adjusted return outcome through the course of market cycles.” the report stated.

Picking the Best: “At the core of the Total Portfolio Approach is the idea that each investment should earn its way into the portfolio,” wrote Hyde, head of asset allocation for New Zealand Super. “That is, each investment should be sufficiently attractive relative to the set of available alternatives to warrant its inclusion in the portfolio.” He described this method as “competition for capital.”

Unified Culture: Organizing investment offices as separate fiefdoms often fails to deliver the best result for an organization overall, so TPA outlines a collaborative setup. In a fund that adopts TPA, the CIO should “nurture a collaborative team and set of norms built on agility and long-termism,” wrote Swee Chiang Chiam, head of total portfolio policy and allocation at Singapore’s GIC.

Implementation challenges

The implementation of the Total Portfolio Approach will vary across different allocators. What works for a university endowment might not work for a public pension fund, and vice versa.

“By now, it should be abundantly clear that adopting TPA is a full-on transformation exercise, and not something to be embarked on lightly,” wrote Jayne Bok, head of Asia investments at WTW, in the CAIA report.

Implementing a Total Portfolio Approach starts at the board level, says CAIA’s Bowman, and is not something that happens overnight.

“The board really is the fulcrum of the whole process,” Bowman says. “If the board is not aligned and cheerleading and fully supportive of moving toward a different level of empowerment and separation of responsibilities down to the CIO and the staff, then it’s going to be a very short change management process that is not going to work very well. So this is a baby-step process that has to start with, probably, the CIO engaging the board [about] some of the benefits of taking a multi-year progressive approach to try implementing some of these elements in small form and testing them out, getting more and more support, and eventually continuing down that path.”

Implementing TPA can be especially difficult for public pension funds, Bowman says.

“I think public pensions in the U.S. probably have a bigger challenge, all else equal, than most other types of asset owners,” he says. “If you’re going to break things, change things, take risks—which is what good leaders do—that requires things to become inefficient, that requires them to become uncomfortable, that requires probably some attrition and some change-up and some tough discussions, all of which eventually leads to progress. But that’s a really hard thing to ask of a public pension CIO that might only be there four years that has a board that has all of these other competing masters and motivations.”