Investing in emerging markets has become an increasingly popular choice for many as these nations generally have higher growth prospects, lower levels of debt and more favorable demographic profiles than their developed market cousins. However, a broad risk off trade has hit stocks in these countries extremely hard as investors the world over look for lower risk options in more familiar regions of the world. This has been especially the case in the world’s top emerging market of China. The nation has been in focus as of late for a number of reasons, all of them bad, as many are beginning to grow worried that the country is going to have a hard landing.
First, inflation remains relatively high and a housing bubble continues to be a problem, as many homes are not affordable to the average Chinese citizen in the country’s largest cities. Beyond this, worries over growth in the nation are also beginning to cause some level of concern as well. The latest GDP growth report for China came in at "just" 9.1% which, while still at a high level, came in below expectations which called for growth of 9.3% in year-over-year terms. Furthermore, it represents a continued decline in growth rates for the country as the year-over-year growth was 9.5% in the second quarter and 9.7% in the first quarter of this year, suggesting declining prospects for the nation heading into 2011′s home stretch.
Thanks to these recent events, one of the more unique China ETFs currently on the market today, the Market Vectors China ETF (PEK) looks to be in focus. The product is different in that it follows the CSI 300 Index, which consists of 300 A-Shares stocks listed on the Shenzen or Shanghai stock exchanges. While this may sound similar to many other products in the space, it is actually unlike anything else currently offered in the U.S. market. That is because PEK tracks this index by investing in swaps and other derivative instruments and it doesn’t actually buy up A-Shares. In fact, A-Shares are pretty much closed off to foreign investors and are only available to a select few that have been approved for the "Qualified Foreign Institutional Investor" program.
As a result, in order to gain exposure to this market, the fund has to find counterparties who have this QFII approval and engage them in swaps. Thanks to this structure, which forces investors to bid up the price of the limited amount of securities available in the program, PEK often trades at a premium to its underlying holdings, often times by as much as 10%. With that being said, recent turmoil in this emerging market has pushed demand for Chinese securities sharply lower and has eroded the premium that PEK usually exhibits over its NAV. In fact, the fund was recently trading at a discount although this has since stabilized at a small premium once again, although it is now only in the neighborhood of 1%-2%.
Given the collapse in the traditional premium over the past few weeks, investors have to be considering that PEK could be due for a bounce back, if not in share price than at least in premiums. For investors, this would amount to the same thing and result in quick gains for the product, especially if the fund returns to premiums it saw earlier in the year as evidenced by the chart below:
However, it is important to note that this is a relatively small time frame and that investors should probably consider longer time periods instead. Luckily for investors seeking to take a longer term view into account, a fund trading on Hong Kong’s exchange could offer up some clues. The iShares FTSE A50 China Index ETF (HK:2823) follows a similar index of A-Shares securities, again using the QFII system to gain exposure. Although the two indexes involved are not identical, they do exhibit similar premium/discount histories as seen in the chart below:
So while investors could see a return to high premiums it is not necessarily a done deal nor is it destined to happen right away. If the Hong Kong listed security is any guide, reversion to the mean in this respect is uncertain at best and more likely impossible to predict. After all, although PEK saw a move to negatives for a small period of time, the Hong Kong listed product did not see a similar move lower into discount territory. Instead, it appears to be a phenomenon exclusive to the broader CSI 300 index as opposed to the more concentrated Hong Kong listed fund. With that being said, if China manages to avoid a hard landing and if the country can stabilize its economy in short order, it seems likely that a return to higher premiums, if accompanied by increased U.S. investment demand, could be in the future for this ETF from Van Eck.
Disclosure: No positions at time of writing.
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