By Patricia Oey
Improving Chinese economic data and relatively low valuations have attracted strong inflows into Chinese equity exchange-traded funds over the past few weeks. Many assume a cap-weighted ETF provides broad and direct exposure to a country’s stock market. But the Chinese equity universe is different because China continues to maintain tight capital controls. Mainland China-listed A-Shares that trade in Shanghai and Shenzhen are not accessible to most foreign investors; as a result, most China index funds domiciled outside of China invest only in Chinese companies whose shares are listed in Hong Kong (H-Shares, Red Chips, and P-Chips) and/or New York. So, while the total universe of Chinese equities includes shares listed in China, Hong Kong, and New York, only about 30% (as measured by market cap) is readily investable by foreign investors. For an in-depth explanation of the differences among A-Shares, B-Shares, H-Shares, Red Chips, and P-Chips, please refer to my Hong Kong-based colleague Jackie Choy's article on the topic.
Over the past few months, the Chinese government has made some moves to open up the domestic Chinese equity market and attract more institutional investors. Starting in 2002, foreign institutional investors who want to purchase domestically-listed securities, or A-Shares, had to be granted a qualified foreign institutional investor license, or a QFII. Although this program has been in place for more than a decade, the Chinese government has kept investment quotas low, so foreign ownership still accounts for a very small 1%-2% of the local Chinese market. However, the Chinese government is now planning to significantly expand the QFII program (as well as its RQFII program, which is currently aimed at Hong Kong investment firms), as part of its overall efforts to liberalize its capital markets and currency.
There have been other developments of note. First, a new guideline was issued by the Shanghai Stock Exchange that listed companies pay dividends amounting to more than 30% of their annual profit. Firms that don't meet this threshold should issue a statement explaining why they didn't meet this target and their plans for any undistributed cash. Second, at the beginning of this year, China instituted a new sliding scale on the taxation of stock dividends to promote more long-term investing in a market with a strong retail presence focused on short-term trading. Whereas previously all dividends were taxed at 10%, dividends paid by stocks held less than one month are now taxed at 20%, dividends from stocks held between one month and one year at 10%, and dividends from stocks held for more than one year at 5%. These moves may be a precursor to allowing pension and housing provident funds to invest in the securities market. Currently, these entities can invest only in national bonds or keep their funds in traditional bank deposit accounts. In the short term, these efforts may provide a boost to Shanghai- and Shenzhen-listed shares, which have been underperforming overseas listings over the past three years. Over the longer term, we think these initiatives will be positive for the development of a robust and dynamic equity market in China.
PEK: The A-Share ETF
There is currently one U.S.-listed ETF that provides access to China A-shares -- Market Vectors China (PEK). This ETF tracks the CSI 300 Index, which is a modified free-float cap-weighted index of 300 companies listed on the Shenzhen Stock Exchange and/or the Shanghai Stock Exchange. Relative to a popular Chinese ETF such as SPDR S&P China (GXC), which invests only in Hong Kong- and U.S.-listed Chinese stocks, PEK is better diversified -- it is not as top-heavy, with a weighted average portfolio market cap of $11 billion, which is about a third the weighted average market cap of GXC's portfolio. China's mega-cap names such as China Mobile (CHL), CNOOC (CEO), and Baidu (BIDU) are not listed in China, so the CSI 300 Index has significantly lower weightings in the telecoms, energy, and technology sectors relative to GXC. Without these outsized exposures and a more diverse investable universe, PEK has higher weightings in industrials, materials, and consumer names. And while PEK, like GXC, has a large weighting in the financials sector (35%-40%), PEK has a relatively smaller exposure to the big four state-owned banks. As for correlations, while GXC has had a 76% correlation to the S&P 500 over the past five years, the CSI 300 (in yuan) has had a very low 42% correlation to the S&P 500. While the planned liberalization of the A-Share market may drive up correlations in the coming years, it will likely be a slow process. As such, PEK should provide diversification benefits, especially for investors with insufficient exposure to emerging markets.
The "closed" nature of the China A-Share universe has an impact on market dynamics and creates additional risks. A-Shares tend to be more volatile than their overseas counterparts. The CSI 300's five-year annualized standard deviation of returns was 34%, versus the S&P 500's 19% and GXC's 31%. A-Shares have also historically traded at a premium to their H-Share counterparts, but less so in recent years. From Jan. 1, 2010, to Dec. 31, 2012, the A-Share premium reached a high of around 40% in the third quarter of 2011. But more recently, A-Shares have been trading at around a 3% discount to their H-Share counterparts, as foreign investors have been more optimistic about China's outlook, relative to domestic Chinese investors.
PEK's Structure Carries Additional Risks
The aforementioned regulatory changes may provide a tailwind to Chinese A-Shares in the near term; however, investors need to understand the unique structure and mechanics of PEK when considering this fund. PEK employs synthetic replication to track the CSI 300 by purchasing index swaps from Credit Suisse (a QFII license holder), which exposes the fund to counterparty risk. When foreign demand for A-Share exposure is strong, and because licensed foreign entities are limited in how much they can invest in A-Shares, the price and availability of CSI 300 Index swaps are impacted by supply and demand and a swap provider's ability to hedge its exposure. Over the past year, PEK traded at an average premium to its NAV of 5.7%. This was driven primarily by a "scarcity premium" in the price of CSI 300 Index swaps. PEK can also trade at a discount to NAV when there is heavy selling of the fund and A-Share swaps. Van Eck, the advisor to PEK, has stated that if it is unable to source CSI 300 swaps, it could impact the creation process and lead the fund's market price to stray from its NAV. In addition, capital gains realized by QFIIs on the sale of A-Shares are likely subject to tax in China; however, the precise method of calculating and collecting these taxes has not been determined. There is a risk that local tax authorities may seek to collect tax on capital gains realized by QFIIs on the sale of A-Shares, and this liability may be borne by PEK. There is also a risk that the Chinese regulators could change QFII and capital control rules that would impact PEK's ability to gain access to A-Share index swaps.
Finally, we note that PEK is a small fund with only $35 million in assets. There is always a risk that a fund sponsor will shut down a small fund, in which case investors should receive net asset value upon liquidation. Also worth noting is that this fund is very thinly traded, with average daily trading volume of around 14,000 shares. As such, its bid-ask spreads tend to be fairly wide. We recommend investors use limit orders when buying and selling this fund in order to ensure good execution. Lastly, PEK's expense ratio of 0.72% is higher than GXC's 0.59%, partly because PEK is a more expensive product to manage.
Disclosure: Morningstar, Inc. licenses its indexes to institutions for a variety of reasons, including the creation of investment products and the benchmarking of existing products. When licensing indexes for the creation or benchmarking of investment products, Morningstar receives fees that are mainly based on fund assets under management. As of Sept. 30, 2012, AlphaPro Management, BlackRock Asset Management, First Asset, First Trust, Invesco, Merrill Lynch, Northern Trust, Nuveen, and Van Eck license one or more Morningstar indexes for this purpose. These investment products are not sponsored, issued, marketed, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in any investment product based on or benchmarked against a Morningstar index.