To say that stock markets in China have been volatile over the last couple of months is making a major understatement. It’s a lot closer to accurate to say that Chinese stock markets have been on a roller coaster, but even that metaphor blanches in light of the reality. Stock market indices in China have been swinging wildly as investors look to lock in their remaining profits at every opportunity, while the government keeps propping markets up by exhorting everyone to buy and pulling strings and twisting arms behind the curtain to make sure the job gets done.

In the spirit of whatever it takes to get the job done, the People’s Bank of China recently announced a significant devaluation of the Chinese yuan, which will give the economy a boost as Chinese products are now more competitive abroad.

Looking at the bigger picture, it’s been said for many years that politics and financial markets do not mix well, and it seems likely that China is soon going to provide us with another object lesson validating this point.

Research firm FactSet published a report titled Mitigating Portfolio Risk from the Yuan’s Devaluation on August 21st. This report outlined a model strategy for minimizing the impact of China on a portfolio based on the S&P 500 index.

Strategy to mitigate China portfolio risk

China Exposure

China Exposure

The first step in creating a strategy to mitigate China risk is to identify which firms have a high exposure to China. For this study, FactSet Senior Product Manager Jeremy Zhou used “% revenue exposure” to China as his key criteria. He then analyzed China revenue exposure for all S&P 500 firms, ranking them from highest to lowest. All firms that earned 20% or more of revenues from China was defined as highly exposed to China.

Zhou also developed a number of weighting modifications on the highly China exposed firms to reduce their impact on a portfolio based on the S&P 500. The modifications included underweighting the highly exposed firms by 50% or 75% compared to their original index weights or removing them fully from the S&P 500 portfolio. In effect, Zhou created three separate portfolios based on S&P 500 firms designed to mitigate China exposure risk using underweighting or complete avoidance.

When he backtested the performance of these three modified portfolios against the S&P 500 so far this month (July 31, 2015 to August 17, 2015) compared to see if the returns and Sharpe Ratios of the modified portfolios outperformed the unmodified S&P 500 index..

The graphics above illustrate the backtested results. For month-to-date returns, all three modified portfolios notably outperformed the S&P 500. That means both underweighting and total avoidance of the highly China exposed companies improved returns. Zhou also noted that the less weight assigned to the China exposed companies, the better the results. The 100% China avoidance portfolio produced a return almost double that of the S&P 500 for the period.