China offers investors a potent mixture of cyclical and policy risks. We were reminded of that this week after the government introduced measures to slow the growth of housing prices, which in some cities looks to be overheating. Time will tell if the boys in Beijing can steer the ship to more open water. For ETF investors, it hasn't been a pleasant journey.
China offers more ETF options than any other market, yet it's not a complicated group of funds to understand. This is mainly because there are limited share classes available to foreign investors and financials make up a large percentage of the investable universe.
This analysis breaks down China ETFs into two categories; 1) China country benchmark funds, and 2) China strategy indexes. Let's take a look at the benchmark funds first.
China Benchmark ETFs
How much financials exposure would you like?
The main consideration in the benchmark fund group depends on the level of concentration in financials you desire. Companies like ICBC, Bank of China (OTCPK:BACHF), Agricultural Bank of China, China Construction Bank (OTCPK:CICHY), China Life (LFC) are household names for most emerging market investors. It is difficult to avoid Chinese financials; they are single largest country-specific sector in emerging markets representing 7% of the total investable universe according to MSCI. Bigger than either Korea's or Taiwan's IT sectors and more than double the size of Russia's energy sector.
The State dominates
Another important reality of investing in China is that many large Chinese companies are partially privatized state-owned enterprises (SOEs). These include large banks, energy and telecommunications companies. ETF investors are alongside government as shareholders and counting on government policy and management to maximize returns.
Looking at the funds, iShares FTSE China Large Cap (FXI) is the largest China specific ETF and the fourth largest emerging market ETF. The fund tracks the FTSE 25 index represented by H-shares and is a highly concentrated fund with 25 holdings. FXI is heavily exposed to the financial (59% of holdings), telecoms and energy sectors in China. Many of the largest companies in the index face a high level of state ownership and control yet the fund is the ETF proxy for the country.
SPDRS S&P China (GXC) is the deepest major China ETF with over 200 holdings. GXC is less exposed to financials (35% of holdings) and has relatively broad sector exposure. GXC can hold P and N-shares of large companies like Tencent (OTCPK:TCEHY) and Baidu (BIDU), which are exclusions in FXI.
iShares MSCI China (MCHI) tracks the MSCI China index and is a larger more diversified portfolio than its iShares peer FXI with over 130 holdings. Financials represent 39% of sector exposure while energy and telecoms make up the funds other top exposures. MCHI can hold P-shares so has more exposure to the IT sector than FXI for example.
Powershares Golden Dragon (PGJ) is the most unique fund of this group holding only U.S.-listed Chinese companies. Its financials exposure is very small since the big banks don't have U.S. listings. PGJ holds a higher percentage of IT and service-related companies. It is relatively concentrated with only 68 holdings. PGJ has been a weak performer lately due to an ongoing dispute between U.S. regulators and the China-based auditors of the U.S.-listed companies over disclosures. Lack of a resolution could lead to the de-listing of the companies from U.S. stock exchanges.
Market Vectors China (PEK) is the only fund that gives investors exposure to China's A-Share market. PEK tracks the CSI 300 index which consists of 300 A-Share stocks listed on the Shenzen or Shanghai Stock Exchange. The fund does not directly invest in shares; rather it invests in swaps and other types of derivative instruments that have economic characteristics similar to those of China A-Share stocks. This index has heavy exposure to financials (42%) as well as industrials and materials-related companies in China.
Guggenheim China All Cap (YAO) tracks the Alphashares China All-cap index which results in a portfolio similar to GXC since it can hold both P and N-shares. iShares FTSE China (FCHI) is a FTSE index fund that has slightly less exposure to financials than FXI (only 46%) and a deeper portfolio with over 100 securities.
Differences lie in depth and financials exposure
The main differences in the China benchmark ETFs are that FXI offers the heaviest financial exposure while GXC offers the broadest portfolios and sector exposure in the group. PGJ gives investors a completely different strategy focusing mainly on IT and services companies and has very little exposure to banks. YAO and FCHI offer minimal differentiation from the large funds and are less liquid.
FXI is one of the most liquid emerging market ETFs trading over $750m/day. GXC and MCHI trade over $20m/day, while the other benchmark funds trade closer to $1m/day. PEK is somewhat liquid trading around $2.5m/day.
A-shares and ADRs lagged
A two-year chart paints a clear picture. GXC has punished its shareholders the least thanks to its lower financials exposure while PGJ has lagged badly due to accounting concerns and the weak performance of global energy and IT sectors. PEK's performance reflects the weak domestic appetite for equities.
China Strategy ETFs
China strategy ETFs enable investors to utilize differentiated index strategies to access the market. There are seven ETFs outlined in this article investors can consider.
Guggenheim China Small Cap (HAO) tracks the AlphaShares China Small Cap index which includes companies with market capitalizations of between $500k up to $4bn. The fund offers relatively broad sector exposure with the industrial, financials, consumer discretionary and materials sectors having the highest weights respectively.
Guggenheim China Real Estate (TAO) had been a strong performer until recently. TAO tracks the AlphaShares China Real Estate index and holds companies involved in real estate development and management, as well as REITS. TAO is diversified for such a specialized strategy holding over 50 securities that are mostly Hong Kong listed.
Global X China Consumer (CHIQ) tracks the Soloactive China Consumer index. The fund holds retail, consumer services, food, automotive, consumer staples, household goods and healthcare sector companies. Theoretically this fund is well-positioned to benefit from China's transition to a consumer-based economy; however, based on performance its time has not arrived.
iShares MSCI Small Cap (ECNS) tracks the MSCI Small Cap index and selects the bottom 14% by market capitalization. The fund is broad with over 300 holdings. Industrials, financials, consumer discretionary and materials sectors have the highest weights so is similar to small-cap peer HAO.
Guggenheim China Technology (CQQQ) for China technology and IT services exposure. WisdomTree China ex-Financials (CHXF) excludes financial stocks and is therefore more oriented to the energy, materials, industrials, telecoms and consumer staples sectors in China.
Finally EG Shares China Infrastructure (CHXX) gives investors targeted exposure to urban growth in China. The fund follows the Indxx China Infrastructure index which consists of companies active in construction and materials, industrial engineering, metals and mining, real estate, electricity energy and telecommunications.
Not much performance
A two-year chart shows the meager performance of the strategy ETFs relative to FXI with only TAO showing meaningful outperformance. Delivering profitable growth has proven to be elusive for Chinese stocks regardless of the sector or style.
Liquidity varies with size
Among the strategy funds CHIQ, TAO and HAO all trade over $3m/day. The other funds trade $1m/day or below.
A little more background on the share classes
To clarify the share classes, the primary China ETF holdings reflect the 'H' share market; companies incorporated on the mainland and traded in Hong Kong. Additional exposure can be gained from P-shares (shares of Chinese companies incorporated in certain foreign jurisdictions that trade in Hong Kong), and N-shares (shares of Chinese companies traded in the U.S.).
These are not to be confused with the "A" share market that is closed to foreigners and represented by the Shanghai Composite market and Shenzen Stock Exchange. Only PEK gives investor's exposure to A-Shares of the funds listed above through swap arrangements
China's investment case looks tenuous
Significant fixed investment has smoothed over periods of weaker global demand, yet it's unclear how much longer China's fixed asset boom will continue. Following a period of tighter credit, authorities appeared to have engineered a 'soft landing' although recent data on services PMI have that in some doubt. Banks, which have underperformed on margin and asset quality fears, are expected to turn the corner with the economy in 2013. At least that was the expectation coming into 2013.
Yet another unanswered question is whether China is facing its own credit bubble. The state's control of both the lending banks and the main recipients of credit accentuate a moral hazard. Authorities are showing discomfort with the rate of housing price growth in some cities. Politically the country is also at a crossroads. Its National Congress begins this week with popular concerns starting to shift towards governance of lack thereof.
It is difficult to advocate exposure to Chinese country ETFs given the structure of the market and uncertainty regarding its economic recovery. Granted it has been a laggard and may offer value on some parameters. Dividend yields, however, don't suggest so. When the sign says 'Do Not Enter', don't.