ETF Investors Pull $3bn Out of China

LOW COST FUNDS: The summer of volatility in Asia caused investors to run scared - with investors across the globe pulling money out of China ETFs. But the tide has turned

Emma Wall 5 November, 2015 | 8:00AM
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Emma Wall: Hello, and welcome to Morningstar series, "Ask the Expert." I'm Emma Wall and I'm joined today by Jackie Choy, Passive Fund Strategist for Morningstar.

Hi, Jackie.

Jackie Choy: Hi, Emma.

Wall: So, last time we met, you came to London and now, I'm in Hong Kong.

Choy: Welcome to Hong Kong.

Wall: Last time we met was in April/May and we were very buoyant about the Chinese market. We were very positive. We were talking about what a success that connect between the Shanghai Composite and the Hang Seng had been. But it seems we were full of the joys and spring and we spoke too soon because since then the Chinese stock market has rather gone awry.

Choy: Yeah, very volatile indeed. So, at the time we met in April, in the first four months the Chinese equity market rose about like 40% for the Chinese A share market and subsequent to that the market actually continued to rally at around like 13% until early June. But after that we saw that MSCI announced that the A shares would not be included into their international benchmark in their June market review.

And subsequent to that the market tumbled in June, July and we saw market participants as well as regulators step in with different policies and actions to try to stop the decline, including lowering rates, changing margin rules, as well as suspending themselves on listings, et cetera. So, there has a lot happening in the market as well as the landscape itself.

Subsequent to that the markets continued to tumble in fact. In total, in the third quarter we had around 30% of drop in the Chinese equity market. Luckily, back in October, just lately in the last month, we saw some recovery around 10% in the Chinese equity market.

Wall: Still quite significant losses though even though we have seen that uptick. What have flows done? I'm hesitating to guess that perhaps people have been scared and run a mile.

Choy: Well, if you look at the number, well, I will say they are scared off but I'll give you some numbers. We actually saw quite some outflows out of the Chinese equity ETFs. For example, in the U.S.-domiciled ETFs we saw around $2 billion of outflows out from the Chinese equity ETFs.

And in Europe, Europe-domiciled ETFs we had around $0.5 billion of outflows there. Back in Asia, in Hong Kong there is a segment of ETFs called the RQFII ETFs which invests directly into the Chinese A share market. They also had around $0.5 billion of outflows from the ETFs as well. So, that's quite a bit of outflows in there.

But the trend seems to be a little bit reverting lately. We haven't got all the numbers yet, but just looking at the RQFII ETFs we had around $900 million of inflows in the past two months in September and October. We haven't got the full numbers from the U.S. or European-domiciled ETFs yet, but the partial number seems to suggest that money is coming back into the Chinese equity ETFs.

Wall: So, flows are following performance which perhaps is not the right way around. If you are a contrarian investor, you'd say get into the bottom. Of course, investing in these type of markets is tricky. It's easier said than done to be a contrarian investor. You should expect some volatility, although perhaps up 40%, down 30%, up 10% is a bit more than we usually used to in a 12-month period. Aside from bearing in mind there will be volatility what should investors bear in mind when investing in these markets?

Choy: Well, I think for any ETF tracking any market first of all investors should look at and understand the underlying fundamentals of the market itself for which market tracks, which in this particular case, is the Chinese market. So, understand the Chinese policy, the China market. So, that's the first homework you have to do.

The other part when it comes to like investing into the ETFs, there are a few factors that you should look at. First of all, would be the overall costs. Different ETFs track different markets charge you differently. So, for example, our study shows that the ETFs tracking the onshore Chinese equity ETFs do charge you higher than the offshore Chinese equity ETFs. So watch out for that and choose your exposure carefully.

Secondly, watch out for the premium discount levels. Another study of ours shows that the disbursement of premium discount levels on the onshore Chinese equity ETF were larger than the offshore Chinese equity ETFs. So, watch out for that, especially for the U.K. investors because, well, there's only a few hours overlap between when the Chinese equity market opens and the U.K. market opens. So, watch out for that because there could be like different meaning of premium discount levels when you trade ETFs and premium discount obviously isn't implicit cost when it comes to investing into ETFs.

And lastly, do your homework because you do need to understand the actual benchmark that your ETF tracks. So, different ETFs, different benchmarks and when it comes to China, there's onshore and offshore that could give you very different performance.

Wall: And China A shares are the ones that are onshore and the China H shares are the ones that are offshore listed in Hong Kong.

Choy: That's correct.

Wall: Both the db X-trackers and iShares do ETFs which track both of those markets. Should you be feeling brave and investing for the long term? Jackie, thank you very much.

Choy: You're welcome, Emma. Thanks for having me.

Wall: This is Emma Wall for Morningstar. Thank you for watching.

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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Emma Wall  is former Senior International Editor for Morningstar