China Opens Its Onshore Equity Markets To Foreigners

Jul.29.14 | About: Deutsche X-trackers (ASHR)

By Patricia Oey

Morningstar Take
Five exchange-traded funds that provide direct access to China's onshore equity market (China A-shares) have launched over the past year. These launches are notable in that they provide access to an asset class that in the past had been inaccessible to foreign investors. While there is a degree of novelty to these products, China A-shares are an extremely niche asset class and more suitable for those who are very familiar with risks and opportunities of investing in the emerging markets, and especially in China. DB X-trackers Harvest CSI 300 China A-Shares (NYSEARCA:ASHR) (report below) is currently the largest A-share ETF with about $200 million in assets. The other A-share ETFs are significantly smaller and have seen very low asset inflows.

DB X-trackers Harvest CSI 300 China A-Shares provides cap-weighted exposure to the onshore (A-shares) Chinese equity market, where foreign investors have historically had very limited access. This is because China has a "mostly closed" capital account, whereby investors, as well as companies and banks, cannot move money in and out of the country except in accordance with strict rules. Capital account liberalization is part of China's current reform efforts, and the fact that this ETF exists (along with a handful of others that were also launched over the past year) is evidence that China is slowly and carefully trying to open up its capital markets.

At this time, investors have access to Chinese companies via shares listed in Hong Kong (and New York, to a much smaller extent). Some Chinese companies have dual onshore and offshore listings (many in the financial and energy sectors) and some companies are listed only in China (typically mid-cap names), Hong Kong (typically the largest state-controlled firms), or New York (typically Internet and consumer companies). Overall, this CSI 300 Index and the MSCI China Index (which is composed of Hong Kong-listed Chinese companies) have about a 40% overlap. For an in-depth explanation of the differences among the onshore A-shares and B-shares, and the offshore H-shares, red chips, and P-chips, please refer to my Hong Kong-based colleague Jackie Choy's report on the topic.

China A-shares (as measured by the MSCI China A Index, which is very similar to the CSI 300 Index, but priced in U.S. dollars) have had a low 38% correlation to the S&P 500 over the past five years. The correlation is much lower than the 65% correlation between the MSCI China Index and the S&P 500, which would imply that an investment in China A-shares could provide diversification benefits. 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.

As for risk, the MSCI China A Index used to be more volatile than the MSCI China Index, but over the past three years, the annualized standard deviation of returns of the MSCI China A Index was 21%, almost in line with that of the MSCI China Index.

Chinese equities have a relatively short history. The modern day onshore Shanghai and Shenzhen Stock Exchanges opened for trading in 1990 and the first Chinese company to list in Hong Kong occurred soon after. In the early days, it was the larger, fiscally healthier, and politically favored companies who were allowed to list abroad in Hong Kong or New York to draw upon a global investor base. This included companies such as China Mobile (NYSE:CHL) and energy firm CNOOC (NYSE:CEO). As a result, Shenzhen- and Shanghai-listed companies tended to be more mid-cap firms. One of the commonly cited reasons for investing in China A-shares is for a more "complete" exposure to the Chinese investment universe. Adding A-shares exposure would also result in a larger allocation in China, which some say would make sense given the size of the Chinese economy relative to the rest of the world.

While it was almost impossible for foreign investors to gain access to China A-shares in the past, more recently, the Chinese government has made some moves to open up the domestic Chinese equity market to foreign investors. Starting in 2002, foreign institutional investors who want to purchase 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 expanding 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. On a somewhat related matter, index provider MSCI is considering adding China A-shares to the MSCI Emerging Markets Index but is concerned about the current bottlenecks that exist for foreign investors. Some coordination between the Chinese authorities (regarding larger quotas for foreign investors) and MSCI will be needed so that investors will have access to China A-shares should they be added into the MSCI EM Index. Investing in A-shares now before the crowds is another commonly cited reason to buy a fund such as ASHR.

In the past five years to June 2014, the MSCI China A Index has had annualized returns of negative 3.0%, significantly underperforming the MSCI China Index’s 5.0% over the same time period. Reasons for this underperformance include a slowing Chinese economy, falling earnings, and local Chinese investors moving their money into higher returning investment options such as real estate and wealth management products. More recently, at the start of the year, China reopened its IPO market after a 14-month hiatus. This temporary halt was instituted as the government sought to improve oversight and strengthen regulations over the IPO market, which had been plagued by companies with weak financials. All of these issues highlight the risks common to investing in emerging-markets stocks.

Over the long term, the new crop of younger, more liberal-minded leaders should have a positive impact on China's economy and will implement much-needed reforms such as interest-rate liberalization, yuan appreciation, and more competition in industries dominated by state-owned firms--changes that will support stronger growth in domestic consumption. This, combined with a gradual opening of China’s capital accounts and capital markets will likely have a positive impact on Chinese equities over the long term.

Portfolio Construction
This ETF tracks the market-cap-weighted CSI 300 Index, which currently accounts for about 60% of the available market capitalization of both the Shanghai and Shenzhen stock markets. The fund sponsor of ASHR, Deutsche Bank, has an asset-management joint venture in China called Harvest Fund Management, and this entity has a Hong Kong subsidiary, which holds an RQFII license. With this RQFII license, this fund is able to employ full replication to track its index.

This fund levies an annual expense ratio of 0.82%.

Market Vectors China AMC A-Share (NYSEARCA:PEK) also employs full replication to track the CSI 300 Index and charges a slightly lower expense ratio of 0.72%. Those who want onshore and offshore exposure in one fund can consider DB X-trackers Harvest MSCI All China (NYSEARCA:CN), which charges 0.71%.

Going for an actively managed fund might be a better option, as the fund manager can avoid the obvious bad apples--such as firms that are used by the central government as economic policy tools and companies operating in industries with return-crippling excess capacity. There is one China fund with a positive Morningstar Analyst Rating: Matthews China (MCHFX), which is rated Silver. This fund invests in companies domiciled in China, as well as Hong Kong and Taiwan. This fund historically has been less volatile than the MSCI China Index, has lower weightings in the state-controlled financials and energy names, and has a relatively high degree of exposure (27% as of June 2014) to consumer names. The fund's annual fee is 1.25%.

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