Once upon a time, exposure to the Chinese stock market was a binary decision for U.S. investors–they either had it or they didn’t. Thanks in part to increased flexibility in cross-border listings and in part to the proliferation of exchange-traded funds, investors now have countless options for exposure to the world’s second largest economy.
In late 2004, the only ETF option for exposure to China was the FTSE/Xinhua China 25 Index Fund (FXI), a fund that focuses on mega-cap companies and is tilted heavily towards big banks and oil giants. Since then, continued innovation in the ETF industry has afforded investors options for both broader-based exposure and enhanced granularity. Guggenheim and iShares both offer funds focusing on small cap Chinese stocks (HAO and ECNS, respectively), and Guggenheim also offers an all-cap Chinese ETF (YAO) that invests across all market capitalization levels.
Recent years have also seen the debut of a number of sector-specific China ETFs. EGShares offers a China Infrastructure Fund (CHXX), while the Global X suite includes ETFs focusing on consumers (CHIQ), financials (CHIX), materials (CHIM), industrials (CHII), energy (CHIE), and technology (CHIB). Investors have embraced all of these more targeted China options, taking advantage of tools that allow them to fine tune exposure to an economy that has emerged as one of the primary drivers of global economic growth.
One of the latest additions to the ETF lineup further expanded the options for exposure to Chinese stocks. Last month, Van Eck debuted its China ETF (PEK), which seeks to replicate the performance of the CSI 300 Index. That benchmark consists of 300 A-Shares stocks listed on the Shenzen and Shanghai Stock Exchanges, making PEK the first U.S.-listed ETF to offer investors exposure to a corner of the Chinese equity market that has historically been off limits.
In order to understand exactly why PEK is unique, it helps to understand the different classes of Chinese equity securities:
- A-Shares: These securities are traded on the Shanghai and Shenzhen Stock Exchanges in renminbi, the currency of mainland China (sometimes referred to as the “yuan”). Historically, the Chinese government had placed restrictions on A-Shares in an effort to regulate the movement of capital into and out of the country, but these restrictions have eased in recent years (more on this below).
- B-Shares: These securities are also traded on the Shanghai and Shenzhen Exchange, but are denominated in foreign currencies besides the renminbi; in Shanghai B-Shares are traded in U.S. dollars, while in Shenzhen they are traded in Hong Kong dollars. B-Shares are available to both Chinese citizens and foreign investors.
- N-Shares: This term refers to companies listed on U.S. exchanges, including the NASDAQ, New York Stock Exchange, and American Stock Exchange, but that have their main business operations in mainland China. Examples of N-Shares include China Telecom (NYSE: CHA), China National Offshore Oil Corp (NYSE: CEO), and China Precision Steel (NASDAQ: CPSL).
- H-Shares / Red Chips: These securities are stocks of companies incorporated in mainland China that are traded on the Hong Kong Stock Exchange and denominated in Hong Kong dollars (it is not uncommon for companies to have shares listed on both the HKSE and one of the two major exchanges in mainland China). H-Shares often trade at a considerable discount to the related A-Shares, a result of the restrictions put in place by the Chinese government.
Story Behind PEK
Historically, the Chinese government had placed restrictions on A-Shares, preventing foreign individuals and organizations from buying these securities in an effort to restrict the movement of capital into and out of the country. In recent years, however, these restrictions have begun to ease. In 2002 Beijing launched the Qualified Foreign Institutional Investor (QFII) program, which allows approved foreign institutional investors to access the A-Share market. The China Securities Regulatory Commission issued four QFII licenses in October, bringing the total number of institutions approved under the plan to 103.
After a firm’s application for a QFII license has been approved, the institution must obtain an investment quota from the State Administration of Foreign Exchange before the institution can begin buying A-Shares. Once granted a QFII license, institutions face restrictions on investing activity. The maximum investment from a single QFII currently stands at $1 billion (raised from $800 million last year), and foreign insurers, pension funds, and mutual funds are subject to a three month lock-up period.
Van Eck, the issuer behind PEK, hasn’t yet been granted QFII status. As such, the underlying holdings of PEK aren’t the actual stocks that comprise the CSI 300 Index. Instead, the fund invests in swaps that are linked to the return of the China A-Shares market. Currently, the counterparty to the swaps held by PEK is Credit Suisse Securities (Europe) Ltd., an institution that has been approved as a QFII and as such maintains the ability to invest directly in A-Shares.
Because PEK offers exposure to securities that aren’t otherwise available to U.S. investors, the China A-Shares ETF maintains a risk/return profile that is unique from other products in the China Equities ETFdb Category. A-Shares account for nearly three quarters of China’s equity market, meaning that only a fraction of the world’s second-largest economy is accessible to foreign investors. While many companies listed on the Shanghai and Shenzhen Stock Exchanges are also available on other exchanges (e.g., as H-Shares or Red Chips), there is a sizable universe of companies that are only accessible to Chinese citizens or QFIIs. There are nearly 2,000 stocks listed on the Shanghai and Shenzhen exchanges, while the H-Shares market includes only about 250 securities and the N-Shares market includes about 430 stocks.
Moreover, Chinese companies listed on international exchanges tend to be more mature firms that generate revenues from global operations. The A-Shares market, on the other hand, is more likely to include younger Chinese companies that are driven by domestic consumption, and as such may be more of a “pure play” on the Chinese economy. Examples of companies available through the A-Share market include SAIC Motor (China’s largest auto company), Kweichow Moutai (a popular Chinese liquor brand), and China Pacific Insurance Group (the fastest-growing insurance company in the country).
A-Shares are the only way for investors to access a significant portion of China’s equity market, making PEK an attractive option for anyone looking to achieve well rounded exposure to one of the world’s largest and fastest-growing economies. But in order to offer this unique exposure, PEK utilizes a unique structure that introduces some additional risk factors.
PEK is subject to many of the same risk factors that influence all Chinese stocks–or all emerging markets equities for that matter. But there are some additional risk factors that arise out of the unique swap-based structure of this product. As mentioned above, although foreign access to China’s A-Shares market has become possible in recent years, there are still significant restrictions in place–most notably the $1 billion limit per QFII. As the “home country bias” has gradually slipped away and investors have begun making larger allocations to emerging markets in their portfolios, demand for Chinese stocks has skyrocketed. As a result, demand for A-Shares exposure still far outweighs the supply–at least in the current environment where China’s red hot economy is expanding rapidly and has emerged as a primary driver of global GDP growth. So those institutions with the ability to offer investors exposure to A-Shares (i.e., QFIIs able to enter into total return swaps) are able to charge a premium for the hard-to-get exposure.
The imbalance between supply and demand for Chinese A-Shares can throw a wrench into the ETF structure. Generally, there are mechanisms in place under the hood of an ETF that prevent shares from deviating materially from the net asset value (NAV) of the underlying assets. But in order for the creation/redemption process to run smoothly, Authorized Participants must be able to exchange a basket of the securities underlying the ETF in exchange for additional shares (which would allow the APs to generate an arbitrage profit if the ETF was trading at a premium). But because there is a limited market for the underlying assets of PEK–swaps linked to the CSI 300 Index or to A-Shares securities in general–the QFIIs that do have access are able to charge a premium to counterparties.
For most ETFs, accumulating the securities that comprise the creation basket is a simple process. But the market for A-Shares swaps is, in some ways, not fully efficient. At times demand far outweighs supply, complicating the creation process. Usually, when shares of an ETF are trading for more than the fund’s NAV, Authorized Participants will exchange a basket of individual securities for shares of the ETF, netting an arbitrage profit in the process. But when the underlying securities (in the case of PEK, A-Shares swaps) are trading at a premium, the ETF premium must reach a certain threshold before the APs are incentivized to create additional shares.
Not surprisingly, PEK has recently been trading at a premium–shares finished last week about 13% higher than the NAV. Since inception (in mid-October) PEK’s premium to NAV has ranged from about 8.5% to 14.5%, a relatively wide range. The presence of a premium (or discount) doesn’t necessarily mean that investors should stay away from PEK, but it does add an additional layer of risk to the security. The returns realized by investors in PEK will depend not only on the performance of the Chinese A-Shares market, but on the movement of the premium. An investor who buys in when PEK is trading at an 8% premium and sells when the premium has reached 10% will pick up some additional return unrelated to the change in price of the underlying stocks. Conversely, if the premium decreases or deflates completely, returns would obviously be impacted in an adverse manner.
PEK is a one-of-a-kind product–in terms of both potential return and risk factors. For those interested in A-Shares exposure, it can be a powerful tool–and the only game in town. But before buying, be sure to do your homework, and understand the risks associated with buying at a premium.
Disclosure: No positions at time of writing.
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