China Rebalancing ETF Pair Trade

As reported in yesterday’s Wall Street Journal, late this summer the Chinese government announced a new policy permitting its mainland citizens to invest in Hong Kong equities. Although the specific timing remains unknown, this would be the first opportunity for mainlanders to diversify their equity holdings without obtaining special government approvals. In addition, the government is reportedly exploring lifting current restrictions on short-selling.

While the two markets are clearly correlated, as shown below there has been an obvious and widening gap in performance between them. A prospective rebalancing trade here using an ETF pair would be to: (1) go short the iShares FTSE/Xinhua China 25 (FXI); and, (2) go long the iShares MSCI Hong Kong Index (EWH).

The Morgan Stanley China A-Shares ETF (CAF)is another short candidate with even higher returns year-to-date (+124%), but would make for a significantly less correlated pairing against the EWH (2007 correlation coefficient of 64% versus 87%).

I don't pretend to know the local investment psychology, but if I were a mainland citizen, I might think hard about diversifying my holdings after this year’s tremendous run, how about you?

FXI ~ YTD Return = 81%; P/E Ratio = 24.6; 20-Day Z-Score = +2.4

EWH ~ YTD Return = 39%; P/E Ratio = 16.3; 20-Day Z-Score = +2.3

Comments

[Frank Li:]

Interesting idea. How liquid are the two ETFs, particularly FXI?

2007 Oct 12 07:33 AM

[jgpietsch:]

Three Month Share Averages -

FXI - 3.7 million
CAF - 0.4 million
WMH - 5.3 million

2007 Oct 12 02:51 PM

[jgpietsch:]

Three Month Share Averages -

FXI - 3.7 million
CAF - 0.4 million
WMH - 5.3 million

2007 Oct 12 02:51 PM

[thyname:]

Good article! I was surprised to read, though, that CAF is not a better short candidate than FXI. I fully understand the correlation part, but aren't A shares going to suffer most from mainald China switch to HK markets?

2007 Oct 12 10:12 AM

[Travis Johnson:]

This all depends somewhat on Chinese investor philosophy, which I don't personally understand particularly well -- but I do think it's important to consider that there is also a flip side here. How often do individual investors seek to leave hot markets? If you were an individual investor in the Shanghai market, holding A shares that you see climbing better than 100% a year, would you want to sell them to buy shares that have recently gone up much less?

If you're a careful and seasoned investor, that's probably "yes" -- but are average Chinese retail investors careful and seasoned? Or are they similar to the Nasdaq day traders of 1999? Remember, US investors had all the freedom in the world to invest overseas as the nasdaq bubble was inflating ... but did they? Not really -- the real foreign investing boom for US investors came many years after the crash.

This is not to say that there isn't demand to diversify internationally among Chinese investors -- I'm sure there is, particularly to get into Hong Kong shares of companies they know, and for companies with dual listings I expect there will be, eventually, a significant arbitrage opportunity as you're noting. I just don't know that it will be as dramatic as many people are predicting -- there's unlikely to be a mass exodus from the A shares, in my opinion, until after (if) that market corrects dramatically.

2007 Oct 12 12:22 PM

[Eugene:]

CAF is not a candidate to short. CAF is a buy. Its share price is 22% currently 22% discount to its NAV. i.e. Each share is traded at 22% lower price compare to the value of the fund's holding for each share! It's truely a screamingly BUY!

2007 Oct 12 02:47 PM

[Eugene:]

Watch out! CAF is not a candidate for short. CAF is currently traded at 22% discount to its NAV. i.e. Each of its share's price is 22% lower than its worth of stock holding. It's a screamly BUY!

2007 Oct 12 02:49 PM

[Eugene:]

HK economy and China mainland economy are two different animals, like US economy and Canada economy. FXI is like Canadian ADR and EWH is like US stock. You can figure out the rest...

2007 Oct 12 02:54 PM

[Haav Bline:]

It seems most of the commentors does not do much research.

CAF are Shanghai A shares, average P/E is much closer to 60 than 20. So even at 20% discount to NAV does not automatically make it a screaming buy. You can argue the Chinese goverment willl not allow the A share market to crash, but it can correct by 20% easily and that will not be good for CAF.

The Short FXI - Long EWH pair trade does not make much sense either. FXI cantains major state own Chinese comanies without local Hong Kong companies. Most of them wer NOT available as A-shares before this year. Those FXI members who have issued A-shares so far has seen their A-shares traded at very large (50-100%) premioum than the H-shares (FXI) of the SAME company. Since the announced scheme, H-Shares has outperformed A-Shares even though the scheme has NOT started yet (delayed by Chinese gov). Free-rider has rush to buy H-shares before the Chinese are allowed to do so. Still, FXI trades at a much lower PE than A-shares, so it is reasonable to expect the Chinese to buy the H-Share first, simply because they know those companies.

The local Hong Kong stocks that are part of the EWH are trading at a still lower PE. You can have faith that they will benefits as well because they are better value than the H-share and even much better value than the A-shares.

There are only two paroblems left in this strategy:

1. The Chinese are not value investers, most of them are momentum investors. Low PE don't mean much to them.

2. The Chinese goverment set a limit to the amount of money that can flow to Hong Kong this way. They can increase or decrease that number at any time. The objective of the scheme afterall is to let off some hot air in the A-share market.

I have been long FXI for 2 years, I am not adding to my position, but not ready to short it. I have been adding positons to EWH for 4 months. May take profit of FXI but to more patient with the EWH.

2007 Oct 15 02:42 AM

[betaboy3000:]

Actually, your logic is wrong. FXI consists specifically of H shares and red chips listed on the Hong Kong exchange. Shorting them would accomplish the reverse of what you suggest.

www.ftse.com/objects/c...

EWH has outperformed FXI specifically because it is the Chinese component of stocks on the Hong Kong Hang Seng.

FXI and CAF would be the logical pairing, not FXI and EWH.

2007 Oct 18 07:34 AM

[User 115120:]

It is a good article for an ordinary investor, easy to understand and very helpful.

2007 Oct 19 11:24 AM

[jgpietsch:]

Recognizing that this was a controversial post based on SeekingAlpha.com commentary, here is a follow through post reporting how the hypothetical China Rebalancing Pairs Trade would have performed through yesterday's close -- a) since posted on the morning of October 11th; and, b) since the FXI's short-term moving average first reversed. These results assume equal dollar weightings and no commissions.

a) Since Posted (10/11):

> Short CAF/ Long EWH +14.9%
> Short FXI/ Long EWH -00.1%

b) Since First FXI 3-Day MA Down Turn (10/22):

> Short CAF/ Long EWH +8.0%
> Short FXI/ Long EWH +5.4%

A proposed change by the Chinese government to allow share classes to float together no doubt helped significantly. A couple "comments on the comments:"

1) Note how the use of the long/short combination reduced the risk of "being early" with this trade idea (FXI is actually higher since the 11th).

2) It is true that the CAF is a closed-end ETF trading below its NAV. It has been my observation, however, that such NAV mispricings often persist for extended periods of time and shouldn't necessarily preempt a short-term trade backed by a well thought out rational.

2007 Oct 30 01:59 PM

[Big Daddy:]

Your Short FXI/ Long EWH was a sweet winner.
Not so much your commenters...

2008 May 24 04:43 PM