On August 18, the US State Department sent a letter to the boards of US colleges and universities warning them of Chinese influence on campuses. The letter also highlighted the risks of owning Chinese equities and suggested endowments divest from Chinese companies listed in the United States as well as Chinese companies placed on the US Commerce Department’s “Entity List.” In this piece, we provide context for the US government recommendation, highlight practical considerations if institutions elect to comply, and encourage institutions to reaffirm their approach to investing in Chinese equities.

At this juncture, divesting from Chinese companies is a US government suggestion rather than a mandate or new regulation. It comes as US-China relations are at a low point. The key rationale the State Department cited for divesting from US-listed China stocks is the risk that these companies may be forced to delist from US exchanges by the end of 2021 if they do not submit their audit work papers to the US Public Company Accounting Oversight Board. Submitting those papers is one of the recommendations President Trump’s Working Group on Financial Markets issued in July. However, current Chinese law prohibits Chinese companies from turning over such documents to foreign governments.

While the probability that Chinese companies may be forced to delist from the United States seems to be increasing, the risk for investors may be limited. First, just three companies account for more than 66% of the nearly $1.0 trillion market cap of US-listed China American depository receipts (ADRs).^[1]The three companies are Alibaba (56%), JD . com (6%), and Pinduoduo (4%). Second, Chinese companies can hedge US delisting risks by having secondary listings. Given that these shares are fungible, investors can swap across listings. The largest company, Alibaba, already has a Hong Kong listing, and other large companies with ADRs are expected to follow shortly.

Regarding Chinese companies on the Entity List, few are listed on public exchanges. In fact, it includes just ten public companies, which represent around $113 billion in market capitalization and 0.14% of the MSCI Emerging Markets Index. Ultimately, the exposure to Chinese Entity List companies is quite small and something that could be avoided with little disruption to portfolio returns.

For investors that want to follow the State Department’s advice, there is a practical issue—how should they divest from Chinese equities without divesting from emerging markets equities as a whole? Many investors have China exposure through emerging markets equity managers or broad index products. They would need to put pressure on mangers to sell these stocks, withdraw from emerging markets equity funds, or possibly ask managers or index funds to provide an option that excludes the Chinese stocks. Given the current lack of “Emerging Markets ex China” products, this means having to potentially dump these equities altogether.

Divesting from equities of the world’s second-largest economy can be done, but it requires choices that may have negative implications for long-term portfolio performance. Given the political climate, institutions should reaffirm that investing in China aligns with their investment and institutional principles. For many allocators, the decision may be to continue to let investment managers weigh the risks and benefits of owning individual stocks.

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Aaron Costello, Managing Director on Cambridge Associates’ Global Investment Research Team