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Innovation has become standard in the ETF industry in recent years, as dozens of issuers have continued to roll out exciting new products offering exposure to new asset classes and investment strategies. The climb to 1,300 funds - more than doubling the size of the ETF lineup in just a few years - has been driven primarily by innovation, not duplication.

One of the latest developments focuses on one of the world’s most important economies: China. While there are more than a dozen options in the China Equities ETFdb Category that can tap into the country’s stock markets, there have historically not been many options available for those looking to invest in Chinese bonds. That has changed in 2011, with the introduction of a number of financial products that focus exclusively on debt denominated in the Chinese currency.

Guggenheim won the race to the finish line, rolling out the first China bond ETF, the Yuan Bond ETF (NYSEARCA:RMB) last month. PowerShares was just a step behind, debuting its Dim Sum Bond Portfolio (NYSEARCA:DSUM) just a day later. Then even more recently, Van Eck stepped up to the plate with a Dim Sum fund of its own, the Market Vectors Renminbi Bond ETF (NYSEARCA:CHLC), which debuted in mid-October.

The launch of these funds is obviously an exciting development for investors. They open up a previously inaccessible asset class that has the potential to bring both valuable return enhancement and diversification benefits. Below, we highlight everything advisors considering a position in these funds need to know before establishing a position for their clients:

1. Where’s The Yield?

International debt - particularly emerging market debt - has become popular in part because this asset class generally offers a considerably higher yield than the paltry returns available from U.S. securities. But those expecting eye-popping yields on China bond ETFs might be disappointed. None of the new funds offer overwhelming current returns.

That’s because the bonds that make up these ETFs are generally toward the short end of the duration spectrum. The index to which RMB is linked had a weighted average maturity of just 2.6 years through August. At the end of the third quarter, DSUM’s effective duration was just 2.9 years. Meanwhile, CHLC also has a very short term focus, as close to 90% of the bonds mature in five years or less.

The focus on short-term bonds results in relatively low yields on these products, though the current returns may look rather meaty compared to short-term U.S. bond ETFs. But if you are in the market for double digit distribution yields, you’ll have to look elsewhere. Dim Sum bonds may offer an upgrade from traditional Western debt, but aren’t anywhere close to 10%.

2. Currency Exposure Is There ... Kinda

The real appeal of Chinese bonds is the ability to participate in anticipated increases in the value of the Chinese currency relative to the U.S. dollar. In coming years, the renminbi is expected to appreciate as Beijing gives more flexibility to a currency that many in the international community believe has been depressed historically to boost the Chinese export market.

It should be noted that there are, in effect, multiple versions of the Chinese currency. The renminbi is traded in mainland China, while the yuan is traded offshore in Hong Kong (the onshore currency is often denominated as CNY while the offshore version is shown as CNH). The values of these two currencies generally move in unison, but it is not unprecedented for meaningful deviations in value to occur. The offshore CNH generally trades at a premium to the CNY currency, but that relationship inverted in September amidst a steep sell-off in risky assets.

U.S.-listed Dim Sum bond ETFs generally offer exposure to the offshore version of the Chinese currency, a distinction that may not have a huge impact on returns but is certainly worth noting.

3. Understanding Dim Sum

All three of the China bond ETFs currently available to U.S. investors hold securities traded in the Dim Sum bond market. It’s important to understand exactly what the Dim Sum market is, and what types of securities are traded there. The Dim Sum bond market first popped up in 2007, but developments in 2010 had a meaningful impact on expanding the scope of the space. That’s when banks and supranational entities were permitted to issue RMB bonds in Hong Kong, significantly expanding the universe of potential issuers.

While most Dim Sum bonds are issued by Chinese entities, these developments have opened up the market to firms from around the globe. It’s important to recognize that the Dim Sum bond market is young - meaning that the liquidity available may not be any near to on par with Western bond markets - and that the lineup of issuers is no longer limited to Chinese corporations and governments.

4. Impact of Cash Creations

Generally, new shares of an ETF can be created when an authorized participant exchanges a basket of the underlying securities for shares of the fund. In certain cases, however, it is possible for APs simply to deliver cash, which the fund manager must then invest in the underlying holdings of the ETF.

DSUM’s prospectus notes that with the nature of the underlying assets - many of the bonds that make up the fund are illiquid - cash creations will be somewhat frequent. RMB similarly notes that unlike most ETFs, that fund “may effect creations and redemptions for cash, rather than in-kind.”

There’s nothing shady or inherently wrong with this approach. Because many of the component bonds to not trade regularly with heavy volumes, the cash creation feature is necessary in certain asset classes to ensure that the creation/redemption mechanism can function properly. So this is no trick or major red flag, but it is worth noting because it can impact the tax efficiency and tracking efficiency of the fund.

Currently, none of the three Dim Sum bond ETFs have significant cash allocations. But if these funds begin to grow quickly - and it would be a surprise if they didn’t - it might be interesting to see how quickly they are able to deploy new cash, and if they are able to do so.

5. Western Influence

The portfolios of all three consist of a number of Chinese issuers, including both government agencies and corporations. But while every bond held by these funds is denominated in the Chinese currency, not every debt issue necessarily comes from a local Chinese entity.

One of the largest positions in RMB is in a bond issued by European consumer products giant Unilever, while DSUM and CHLC include bonds issued by carmaker Volkswagen. Again, this isn’t necessarily a major issue. The primary appeal of these funds is in the currency exposure, which is very pure (noting the onshore vs. offshore issue highlighted above). But the presence of some Western issuers is probably worth noting as well, as it impacts the risk/return profile achieved.

6. Expense Gap Is Meaningful

Generally, expenses charged by similar products are pretty close. But among China bond ETFs, the differential is pretty significant; DSUM charges 0.45% while RMB charges 0.65%. Currently, CHLC is the leader in the space, charging investors just 39 basis points a year in fees. Considering that yields in this space are moderate, that gap is worth considering when weighing the potential options.

7. Light On Diversification

Neither of the China bond ETFs currently on the market has a particularly deep portfolio. All three have about two individual bonds, with securities in both RMB and DSUM accounting for 10% or more of the total portfolio. So there is a fair amount of issuer-specific risk in these funds, and that changes in the price of specific bonds could move the needle for the entire fund.

As mentioned above, the Dim Sum bond market is relatively young. It is widely expected that the number of debt securities traded there will increase significantly in coming years, which would presumably increase the number of securities available for inclusion in these funds. But for the time being, China bond ETFs feature some significant concentrations of exposure.

U.S.-listed ETFs are now serving up exposure to Dim Sum bonds, an exciting development for investors anxious to expand the geographic scope of their fixed income portfolios and potentially enhance the current return delivered. Before diving in, however, there’s a lot to learn about this asset class. The lesson, as always, is to do your homework before jumping in to a position.

Disclosure: No positions at time of writing.

Disclaimer: ETF Database is not an investment advisor, and any content published by ETF Database does not constitute individual investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. From time to time, issuers of exchange-traded products mentioned herein may place paid advertisements with ETF Database. All content on ETF Database is produced independently of any advertising relationships.

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Source: Everything You Need To Know About China Bond ETFs