How to Use ETFs to Invest in China

Foreign investors can now access mainland China stocks. If you have a strong stomach for the volatility and confidence in continuation of financial reforms, consider these ETFs

Caroline Gutman 19 December, 2014 | 12:08AM
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China’s economy is no longer seeing the record-breaking double-digit growth rates of the last decade, but investors may not want to overlook the world’s second largest economy just yet. With an impressive 7.5% GDP growth rate expected in 2014 and a stock market that returned almost 40%% year-to-date, China remains an investment worth considering. Still, investing in China requires a strong stomach for the volatility and confidence in continuation of financial reforms.

Because of capital controls and legal restrictions, until recently, foreign investors could access Chinese equities almost exclusively through the Hong Kong stock exchange. But government initiatives, such as the 2013 expansion of the Registered Qualified Foreign Institutional Investor (RQFII) quota system and the launch last month of the Shanghai-Hong Kong Stock Connect, which gives Hong Kong investors direct access to Shanghai-listed stocks, have opened up foreign investor access to Mainland-listed stocks. At the same time, these moves have spurred the creation of ETFs tracking these so-called A shares.

In the last year, five new China A-shares ETFs have come to the European market, gathering close to £1.5 billion in assets so far. The two largest are the synthetically replicated db-x trackers CSI 300 ETF (KT4) and the physically replicated db x-trackers Harvest CSI 300 ETF (ASHR), with assets under management of £670 million and £530 million, respectively. More are expected to launch in the coming months.

Why are Investors Turning to A-shares ETFs?

For one, overlap between A-shares and non-A-shares China equity indices is limited. The MSCI China A index and the MSCI China index currently have only 15% overlap in their holdings and share fewer than 30 out of about 150 constituents in the MSCI China index. The largest common company is Ping An Insurance Group, with a 2-3% weighting in each index.

A-shares may also add an extra level of diversification to a globally-balanced portfolio. Over the last 10 years, the MSCI China A index had a correlation of 33% to the S&P 500 and 37% to the MSCI Europe index. By contrast, the broader MSCI China index had a correlation of 62% to the S&P 500 and 71% to the MSCI Europe index. The opening of the A-share market to foreign investors may drive up correlations in the coming years, but it will likely be a slow process.

But before jumping into A-shares ETFs, there are several things investors should consider.

The Chinese government still wields influence on China’s domestic stock market. Policy changes, trading restrictions and government intervention can influence A shares’ performance at both the company and sector levels.

Also, in general, A-shares experience greater volatility than non-domestic Chinese equities. The MSCI China A index had a 10-year standard deviation of 31.8%, versus 26.9% for the MSCI China index, and in one day in December the MSCI China A index dropped 5.6%.

A-shares also pose operational challenges for ETFs. Physically replicated A-shares ETFs must use what is known as the Renminbi Qualified Institutional Investor (RQFII) quota. But as with any quota system, supply and demand dynamics can be distorted. More specifically, once the quota is reached, the fund manager may not be able to acquire an additional RQFII quota, forcing him to suspend the creation of fund units, which could cause the ETF’s market price to diverge from its net asset value (NAV). The ETF will effectively be trading at a premium. Synthetically replicated A-shares ETFs are subject to a similar quota system (known as QFII).

Any changes to the QFII or RQFII quotas and to the trading of Chinese stocks in general, which can be made at any time by the Chinese government, may have a direct impact on A-shares ETF valuations.

And A-shares have become more expensive recently in both absolute and relative terms. While cross-listed companies’ A-shares have traditionally traded at a discount to H-shares – as high as 11% in July – that discrepancy has tightened considerably and even reversed. As of November, A-shares traded at a 10% premium to H-shares, following the launch of the Stock Connect programme.

With the potential to see A-shares added to major indices in the next few years, A-shares may become part and parcel of investors’ diversified portfolios. The Chinese government’s recent financial market liberalisations led MSCI to consider adding China A-shares to its Emerging Markets and ACWI indices, to be decided in mid-2015. But before then, investors can decide for themselves whether to take on or increase their A-shares exposure, and ride the Chinese equity market rollercoaster, through the growing selection of A-shares ETFs.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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Securities Mentioned in Article

Security NamePriceChange (%)Morningstar
Rating
Xtrackers Harvest CSI300 ETF 1D14.80 USD-0.29Rating

About Author

Caroline Gutman  is a passive fund analyst for Morningstar