This article first appeared in The Edge Financial Daily, on November 20, 2015.

CHINA’S rebalancing towards consumption may be the dominant influence in emerging market 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 towards 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 do not 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 towards domestic consumption. While China reported annualised its third-quarter growth of 6.9%, economists at Goldman Sachs recently added their voice to the growing number saying that figure is substantially too high, estimating an expansion of about 5% 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 which did well in producing the inputs to Chinese investment or those which did well in integrating themselves into China’s manufacturing supply and distribution chain.

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

The problem is that, like all indices, they are rear-view mirrors, reflecting what happened in the past rather than what will do well as China transforms and the impact is felt globally.

“That means that any diversified emerging market or developed market investment products (mutual funds or ETFs [exchange-traded funds]) 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 am 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 raw materials or otherwise that China needs to build roads, factories and buildings, it faces a tougher time. The same, with the obvious caveats, can be said of countries like Brazil. If, however, you are exposed to China’s growing consumer economy, you will see, if not capture, a growing market.

For health companies and consumer companies the going looks good but in the case of energy, financial, industrial and materials — not so good.

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

It is also true that capitalisation-weighted indices 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 maximising 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.

The first would be its rise as an exporter and integration into the global economy, and the second, its transformation into something closer to a consumer economy. While the force of this will be felt everywhere, it will have more impact in emerging markets, especially those highly integrated with China.

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

The arguments for index funds are well known and should be put to one side only very reluctantly.

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

The opinions expressed are those of the author, a columnist for Reuters.