Forget A-Share Inclusion; KWEB Is The Best Chinese ETF Play
Summary
- MSCI A-share inclusion has been followed by weak Chinese equity performance.
- However, China has to be a staple of any investor's globally-exposed portfolio.
- Most broad ETFs are dogged down by exposure to state-owned companies; KWEB offers direct exposure to the real driver of Chinese growth: consumer tech.
Several months into MSCI’s (MSCI) much-talked-about, highly-anticipated and symbolic A-share inclusion, Chinese equities haven’t lived up to the billing; around the time of inclusion, the Shanghai Composite entered a bear market.
Shanghai Composite since December 2017. Source: Financial Times.
Yet, amid all of the interest in Chinese equities, MSCI China was never the best way to gain exposure. Trade tensions between the US and China show no signs of abating and there has been little progress in making state-owned monoliths more efficient. In fact, as if deleveraging concerns weren’t already high, regional banks are showing visible signs of strain. As trade tariffs continue to be exchanged, the Chinese firms most affected are those in the business of import and export; the majority of which are state-backed.
Issues with broader indices
I see China like this: consumer-focused and everything else. Addressing the latter, a large number of these firms are state-owned and are seeing tech firms disrupting their business lines. Let’s take financials as an example:
- Bank deposits: Chinese depositors have been taking money out of their banks’ deposit and checking accounts to put into money market funds. In fact, China is now home to the world’s largest money market fund, which is owned by Alibaba’s (BABA) affiliate Ant Financial.
- Payments: It often seems like an exaggeration, but nobody pays with cash in China anymore; it’s all done through online payment platforms. The two most popular, by far, are Alipay and WeChat Pay, from Ant Financial and Tencent (OTCPK:TCEHY), respectively.
- Credit data: Because a large percentage of payments are done over mobile platforms, and because e-commerce platforms all use a form of credit lending for users, these tech firms have the best credit data in China.
Chinese banks simply can’t compete. Therefore, it begs the question as to why investors would want exposure to both financials and tech firms, when the tech firms are eating into Chinese financials’ business lines.
Ultimately, this is the problem with broad index ETFs like the iShares MSCI China (MCHI) or the Xtrackers CSI 300 (ASHR): exposure to state-owned firms dilutes the gains from China’s tech giants. As such, the KraneShares China Internet ETF (NYSEARCA:KWEB) is the most effective way to gain exposure to China's consumer growth.
Performance of KraneShares China Internet (dark blue), iShares MSCI China (light blue) and DWS Xtrackers CSI 300 (purple). Source: Yahoo Finance.
Why China’s tech giants deserve attention
The consumer-focused firms are different. Consumer-focused and tech are effectively one and the same nowadays in China, with a handful of behemoths having fingers in multiple pies. These firms – Baidu (BIDU), Alibaba, Tencent, and JD.com (JD) (collectively known as the BATJ) – represent a third of KWEB’s portfolio.
Company | Weight in KWEB | Weighting in MCHI | BATJ investment/ownership? |
Tencent | 9.57% | 15.34% | Tencent |
Alibaba | 9.16% | 12.92% | Alibaba |
NetEase (NTES) | 8.68% | 1.24% | |
Baidu | 8.29% | 3.89% | Baidu |
JD.com | 6.69% | 1.60% | JD.com and Tencent |
iQIYI (IQ) | 4.79% | N/A | Baidu |
Ctrip (CTRP) | 4.09% | 0.99% | |
Sina (SINA) | 3.95% | 0.31% | |
Autohome (ATHM) | 3.88% | 0.34% | |
Momo (MOMO) | 3.76% | 0.29% | Alibaba |
58.com (WUBA) | 3.65% | 0.37% | Tencent |
TAL Education (TAL) | 3.51% | 0.67% | |
Vipshop (VIPS) | 3.32% | 0.25% | JD.com and Tencent |
YY (YY) | 2.91% | 0.26% | |
China Literature | 2.59% | 0.10% | Tencent |
51Job (JOBS) | 2.52% | 0.14% | |
Weibo (WB) | 2.47% | 0.23% | Alibaba |
Total: | 83.8% | 38.9% |
How the BATJ has stakes in the largest holdings of KWEB, compared to the weightings in MCHI. Source: KraneShares, BlackRock.
What’s interesting in the comparison above is how KWEB’s exposure to China’s tech firms is much broader than MCHI’s. Of the top 17 holdings in KWEB, Alibaba and Tencent represent about a fifth of the weightings; in MCHI, it is three quarters. Every other firm’s weighting is cut in order to increase the weightings of Alibaba and Tencent and to incorporate holdings of state-owned firms. While tech is important in China, there’s certainly more to the industry than just Alibaba and Tencent.
I have spoken before about how Alibaba and Tencent (and the BATJ, in general) seem to have investments in most private tech firms that IPO. The reason for this is that China imposes rather strict capital outflow restrictions on domestic capital, so it can only really be invested onshore. For the likes of the BATJ, it essentially means that domestic venture capital is the only real target for investment. But that doesn’t mean that only having exposure to Alibaba and Tencent (or even the BATJ) is adequate. To me, the problem with MCHI’s overexposure to Alibaba and Tencent is that you fail to get accurate exposure to other huge firms that are driving consumer expenditure growth. Take Ctrip, for example: Chinese tourists are travelling overseas more than ever, and Ctrip is by far and away the largest firm in China’s tourism industry. KWEB offers quadruple the exposure to this.
As a final point, China has been trying to reform its state-owned enterprises for decades. To me, it seems that progress is starting to be made. Liu He – a member of one of China’s highest political bodies, the man in charge of financial reform and in charge of trade negotiations with the US – has been put in charge of state-owned entity reform. Clearly, he is trusted by President Xi to take charge of the most important political processes. But it’s worth considering what state-owned reform would actually entail: restructuring of businesses, merging of entities, laying off employees, refining of business strategy. Whether this takes a year or a decade, business performance will be sacrificed for the longer-term goal of efficiency. As such, it makes no sense to hold on to these companies for the foreseeable future.
Holding a portfolio of the disrupters and the disrupted in one thing, but being on the wrong side of state-owned reform is a bad position. That’s why KWEB is the best way to gain exposure to Chinese growth.
This article was written by
Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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