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By Abraham Bailin

For some time now, fund providers have attempted to open the international forum to U.S. investment. Much of the recent activity has been focused on the emerging-markets space.

Fund providers have continued to launch broadly based funds, in addition to the many region- and nation-specific vehicles that slice the emerging markets into increasingly niche segments. Investors concerned with maintaining international exposure will be interested to find that they have been missing access to nearly one fourth of the emerging-markets universe.

The Missing Piece

The Chinese economy ranks among the largest in the world and accounts for nearly 33% of the emerging-markets space by market capitalization. A majority share of China's market, however, has been cut off from the broad international investing community by regulatory capital controls imposed by the Chinese government. This 'A-share market' commands a 24% of the emerging-markets universe and the lion's share of China's broad domestic-equity pool.

A select few international participants, known as QFIIs, have been granted access to these A shares. Through swap contracts with these QFIIs, Van Eck's Market Vectors China A Share ETF (PEK) provides broad A-share exposure to U.S. investors, tracking the CSI 300 Index in an exchange-traded fund wrapper.

Levying an expense ratio of 0.72%, PEK tracks a modified free-float market-cap-weighted benchmark that represents the 300 largest and most liquid stocks trading on China's domestic A-share market. Constituents must generally have been listed for at least three months, unless their average daily market cap ranks among the A-share market's top 30. The index is reviewed semiannually in January and July but generally maintains a heavy overweighting in the financials sector. Financials, industrials, and consumer discretionary constitute the largest sector weightings, holding 34.2%, 17.0%, and 9.2%, respectively.

QFII Status

This fund's advisor is not currently a QFII, so PEK will not invest directly in the A shares of its underlying index constituents. Instead, PEK will invest no less than 80% of total assets in vehicles whose economic characteristics are substantially identical to the securities that comprise its benchmark index. Until and unless the advisor receives QFII status, the fund will engage in swap contracts that replicate returns of the same index. Investors should note that A-share availability is scarce, and the ability of this fund to meet its investment objective is intimately tied to its ability to find appropriate swap counterparties.

The fund's swap contracts are collateralized by the fund's custodian, Bank of New York, minimizing counter-party risk, and the fund reserves the right to tap a multitude of individual QFIIs as swap counterparties. The total QFII quota amounts to nearly $30 billion, so capital liquidity shouldn't be a major concern anytime soon, but there are reasons for pause.

Taxes and Premiums

PEKs tax status should be considered a major investor concern. Swaps expire, and subject to the requirements of the 1940 act, may also need to be reset from time to time. These expirations will create taxable events.The fund expects to distribute capital gains to its shareholders along with net investment income at least annually, and shareholders will be liable for U.S. federal income taxes at ordinary income rates as these distributions are paid. This schedule should generate short-term capital gains, taxable at ordinary income rates that are due to increase in 2011.

Investors should also note that, subject to the mechanics of the swap contracts this fund uses, PEK is likely to trade at a significant premium to its net asset value. After three days of trading, PEK sits at a 12.30% premium to NAV. If, between the time of purchase and sale of a position in PEK, the premium decreases, the investor will suffer diminished returns. This means that taking a position requires an investor to pay more for the fund than the aggregate value of its underlying constituents.

Like PEK, iShares CSI 300 A-Share Index ETF (Hong Kong ticker 2846 for those who want to check for themselves) tracks the broad Chinese A-share index, though it uses derivative securities called China A-share Access Products. Since its launch in November 2009, the iShares offering has traded at a 1.7% premium to NAV on average. A number of A-shares ETFs trading on the Hong Kong exchange track the CSI 300. WISE-CSI 300 China Tracker (HKSE: 2827) and Deutsche Banc db x-trackers CSI300 Index ETF 2D (HKSE: 3049) currently trade at around a 1% premium to NAV, indicating that PEKs premium may not be sustained.

While Van Eck is not currently a QFII, it has applied for the designation. We wouldn't venture to speculate on the ultimate decision of the Chinese government regarding Van Eck's eligibility, but one can certainly surmise as to the effect it would have on PEK.

Securing QFII status would allow PEK to hold A shares directly, eliminating the need for swap-based exposure. The lack of swaps would allow the fund to trade at NAV, so long as its monetary A-share investment quota was not maxed out, and shares would likely realize a 12.30% downward correction as Van Eck switched from swaps to direct holdings. Premiums are inherent in A-share swap contracts and present current shareholders with significant downside risk. These factors may, however, be tolerable for investors seeking complete international or emerging-markets exposure.

The Competition

Morgan Stanley China A Shares (CAF) is a closed-end fund that provides A-share exposure and may stand as PEK's chief competition going forward. Because Morgan Stanley is a QFII, CAF invests directly in the A shares of Chinese companies, eliminating the difficulties associated with swap-based exposure. Unfortunately, the closed-end fund currently trades at a 7.41% premium to its NAV--though the premium is currently less than that of PEK. Additionally, A shares tend to trade a premium to their internationally traded counterparts. The fund maintains an expense ratio of 1.75% and holds $608 million in assets.

This fund has the potential to fill a major gap in the emerging-markets toolkit for U.S. investors, allowing that they are comfortable with the premium and the tax situation. Despite the premium, this ETF appears to be a true crowd-pleaser. PEK launched on Oct. 14, and after three days of trading holds an average volume of 381,400.

Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including Barclays Global Investors (BGI), First Trust, and ELEMENTS, for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.

Source: Van Eck Cracks Code on China A-Share Exposure but Concerns Remain