Over the past two weeks, portfolio managers at a number of the world’s largest funds have pondered a report from Goldman Sachs. Some of them, choosing to read between the lines, suspect that its 23 pages portend much more than they say out loud about geopolitics, China and the contingency plans forming in some heads.

The question posed in the document is whether the increased and now growing weight of China in the benchmark MSCI Emerging Market index justifies leaving the world’s second-largest economy in this category and creating a separate asset class “EM excluding China ”for the asset management industry. work with. A global team of seven Goldman strategists tackled this technical and intriguing question and make a compelling case for change.

Fund managers who read it say the paper sums up a debate that was only just beginning to unfold on the sidelines, but which was likely to accelerate sharply in the months and years to come. The ramifications of such a change, which would directly or indirectly affect more than $ 10 billion in assets compared to various MSCI indices, are significant enough to mean that the change would not be straightforward. So if you think that’s the likely end point in three to five years, said a Hong Kong-based fund manager, the discussion needs to go in that direction now and index makers need to know that the dynamic is real. .

Goldman’s argument unfolds in three stages. The first depends on China’s disproportionate weight in the MSCI EM index, which has doubled over the past five years to around a third and could soon exceed 40%. Sheer size, rather than the traditional question of whether particular markets have moved to “developed” status, is key here. When Shanghai, Shenzhen and Hong Kong are combined, they represent the second largest stock market in the world. No country has ever had this weight in the emerging markets index and this dominance has a series of important consequences for portfolio managers. An investor looking for a wide range of stories, cycles and exposures in emerging markets, whether global or focused in Asia, doesn’t quite understand this. They receive China’s history – with all its peculiarities and dangers – and an increasingly irrelevant investment hinterland.

The second argument, which fund managers say may require a greater leap of faith than they and others are prepared to take, is that the end of an emerging market index with no exposure to China would still be highly investable. Especially since the weighting of global mutual funds towards non-Chinese emerging markets is currently, according to Goldman, at a decade low. Goldman’s claim here is that while only about half of the stocks in the MSCI EM Index are non-Chinese, they are deep and liquid enough to remain attractive on their own. They are also less and less oriented towards Chinese growth. Indeed, emerging countries excluding China, according to the authors of the report, offer an equal spread of about 20 percent of weightings each between the three largest markets (Taiwan, India and South Korea). This trio, with their penchant for tech hardware and semiconductors, would also offer a rather different industry profile than today, dominated by the huge internet and retail tech stocks that dominate the Chinese market capitalization rankings.

In its final installment, the report cites the experience of when Japan was removed from the MSCI Pan-Asian index in 2001 after it had come to represent 73 percent of the total capitalization. There was, according to the report, no cannibalizing effect after the change: Japan and the region continued to receive cumulative net inflows at constant rates.

Goldman tries to present it all as a series of win-win assumptions. The problem, the fund managers say, is that it has come at a delicate point when the question of China as an investment opportunity for the outside world can now generate very negative opinions. Some of them are based on the last few months of sudden and overwhelming regulatory changes for the market. Others have a grim long-term view of what Xi Jinping’s “common prosperity” rhetoric can mean for business and investment. At the most pessimistic, some now frame the question around scenarios of military escalation around Taiwan. It is not impossible, says one fund manager, to envision a situation in which American clients would feel compelled, for various reasons, to completely remove China from their global exposure.

As it stands, the idea of ​​emerging markets outside of China can be presented as a tribute to the extraordinary growth and attractiveness of its market. Some may decide that such a clue must exist as a form of future contingency.

leo.lewis@ft.com