Why The IShares China Large-Cap ETF Is Not A Good Way Of Gaining Exposure To China

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About: iShares China Large-Cap ETF (FXI)
by: MarketGyrations
Summary

FXI is one of most heavily-traded ETFs available and the one that many people turn to if they are bullish or bearish on China.

The holdings of FIX are skewed towards one sector of the economy and towards companies that are controlled by the government of China.

The performance of companies within FXI can be very different from what they would be if there was no influence from the Chinese government.

If you are bullish or bearish on the future prospects of a particular country, you can use a specific ETF dedicated to that country. In the case of China, there are several ETFs available that focus on China. One of them is the iShares China Large-Cap ETF (FXI), which consists of 50 companies that are all large cap in size.

Based on daily trading volume which numbers in the tens of millions, FXI can be regarded as the most popular ETF for China. In fact, FXI is on the list of top ten ETFs by trading volume. Based on liquidity, FXI is far ahead of all other China ETFs. However, even though many people seem to have settled on FXI, there are a couple of reasons why this ETF is not a good way of playing the China story, regardless of whether you are long or short.

FXI is skewed heavily towards a particular sector

The first thing to take into account is that FXI leans heavily towards one sector, namely financials and banks in particular. This may or may not be a good thing depending on what you are looking for. For some people who are particularly interested in China’s financial sector, it’s a good thing. They want the exposure to the financials.

But other people may want something that is more broad based or more reflective of how the overall economy is doing. Take the U.S. for example. In the S&P500, the financial sector, which is represented by XLF, has underperformed relative to the overall market. But because the financials do not occupy an outsized position relative to the other sectors, the impact has been limited.

Imagine if the same had happened in China and the impact would be quite different. Because financials account for close to half of all holdings, the performance of FXI would be severely constrained by factors such as low interest rates and other monetary or fiscal policies that have held back the XLF in the U.S.

While some may consider FXI the Chinese counterpart to the S&P500, it is more like the XLF due to its heavy exposure to one sector of the economy. It would be better if FXI covered more sectors in a relatively equal manner like the S&P500 does. The table below lists the share of each sector in FXI.

Sector

Share

Financials

45.98%

Communications

20.10%

Energy

11.17%

Real Estate

9.31%

Consumer Discretionary

5.24%

Industrials

5.22%

Utilities

1.12%

Materials

1.12%

Information Technology

0.62%

Source: iShares

Most of FXI consists of state-owned enterprises

However, the biggest issue to be aware of is that most of the companies that comprise FXI are state-owned enterprises (“SOE”) that are controlled by the government of China. FXI contains a total of 50 companies and 30 of them are SOEs. If we just look at the top 10, which accounts for 55.91% of FXI, we can see that seven of them are SOEs for a total of 36.71%. The biggest being China Construction Bank with 8.61%.

In addition, there are several other companies where the government has a significant stake, even though the companies are technically not state-owned enterprises in the sense that the government does not own most of the shares. Examples are Ping An Insurance Co, China Pacific Insurance Group and Anhui Conch Cement Limited. The table below lists all the companies in FXI with SOEs having a “Y” to the right.

Name

Weight (%)

Sector

State-owned

TENCENT HOLDINGS LTD

9.27

Communication

-

CHINA CONSTRUCTION BANK CORP

8.61

Financials

Y

INDUSTRIAL AND COMMERCIAL BANK OF CHINA

6.82

Financials

Y

PING AN INSURANCE (GROUP) CO

6.69

Financials

-

CHINA MOBILE LTD

6.02

Communication

Y

BANK OF CHINA LTD

4.42

Financials

Y

CNOOC LTD

4.17

Energy

Y

CHINA LIFE INSURANCE LTD

3.38

Financials

Y

CHINA PETROLEUM AND CHEMICAL CORP

3.29

Energy

Y

CHINA MERCHANTS BANK LTD

3.24

Financials

-

CHINA OVERSEAS LAND & INVESTMENT L

2.39

Real Estate

Y

AGRICULTURAL BANK OF CHINA LTD

2.38

Financials

Y

PETROCHINA LTD

2.28

Energy

Y

XIAOMI CORP

2.22

Information Technology

-

CHINA RESOURCES LAND LTD

1.99

Real Estate

-

COUNTRY GARDEN HOLDINGS LTD

1.92

Real Estate

-

CHINA PACIFIC INSURANCE (GROUP)

1.76

Financials

-

GEELY AUTOMOBILE HOLDINGS LTD

1.72

Consumer Discretionary

-

SHENZHOU INTERNATIONAL GROUP LTD

1.58

Consumer Discretionary

-

CHINA TOWER CORP LTD

1.47

Communication

Y

CHINA SHENHUA ENERGY LTD

1.28

Energy

Y

ANHUI CONCH CEMENT LTD

1.28

Materials

-

PICC PROPERTY AND CASUALTY LTD

1.27

Financials

Y

CITIC LTD

1.23

Industrials

Y

CHINA UNICOM (HONG KONG) LTD

1.23

Communication

Y

CHINA TELECOM CORP LTD

1.22

Communication

Y

CHINA EVERGRANDE GROUP

1.17

Real Estate

CHINA VANKE LTD

1.12

Real Estate

-

BANK OF COMMUNICATIONS LTD

1.07

Financials

Y

LONGFOR GROUP HOLDINGS LTD

0.98

Real Estate

-

CITIC SECURITIES COMPANY LTD

0.90

Financials

-

POSTAL SAVINGS BANK OF CHINA LTD

0.90

Financials

Y

CHINA CITIC BANK CORP LTD

0.88

Financials

Y

CHINA GAS HOLDINGS LTD

0.87

Utilities

Y

CHINA MINSHENG BANKING CORP LTD

0.81

Financials

-

NEW CHINA LIFE INSURANCE COMPANY

0.80

Financials

Y

CHINA COMMUNICATIONS CONSTRUCTIONS

0.76

Industrials

Y

BYD LTD

0.73

Consumer Discretionary

-

FOSUN INTERNATIONAL LTD

0.63

Industrials

-

CRRC CORP LTD

0.62

Industrials

Y

GUANGZHOU AUTOMOBILE GROUP LTD

0.61

Consumer Discretionary

Y

THE PEOPLES INSURANCE CO (GROUP)

0.59

Financials

Y

HUATAI SECURITIES LTD

0.58

Financials

-

CHINA RAILWAY GROUP LTD

0.54

Industrials

Y

MEITUAN DIANPING

0.53

Consumer Discretionary

-

CHINA RAILWAY CONSTRUCTION CORP

0.40

Industrials

Y

AIR CHINA LTD

0.38

Industrials

Y

GF SECURITIES LTD

0.37

Financials

-

GUOTAI JUNAN SECURITIES COPORATION

0.31

Financials

Y

CHINA EVERBRIGHT BANK LTD

0.25

Financials

Y

What are the drawbacks of owning shares of a SOE or a company that is controlled by a government?

Generally speaking, companies are supposed to look after the interests of shareholders by trying to do everything they can to grow the top and bottom line. The hope is that with growth, the company and its management will reward those people who decided to invest in the company. But this is not necessarily the case with state-owned enterprises.

The prime directive for state-owned enterprises in China, especially the ones in strategic sectors such as banking, telecommunications and energy, is to carry out government policy. Growing earnings is considered to be of lesser importance by management. That is not to say that the government in China is not interested in companies making a profit. The government wants profits as long as companies first do what the government is asking of them. Everything else is gravy.

The big problem with this is that the interests of other shareholders may not align with that of the government and minority shareholders can get hurt in the process. Take the energy sector for instance. Normally, oil companies will raise their prices for refined petroleum if the price of crude oil goes up.

But this can lead to higher inflation, which is something that the government in China may want to keep down because it affects the general population. The Chinese government could order the refiners to hold off on price increases and to maintain existing prices for a while to make sure that discontent among the population is kept in check.

The side effect of this policy is that the margins of the oil companies will take a hit and their profitability is reduced as a result. This is the opposite of what a company is supposed to do by growing profits and creating shareholder value in the process. As a shareholder, you have essentially put money in a company that is not actually looking out for you.

Another example are the banks. The Chinese government can tell state-owned banks how much, when and to whom to lend. This is regardless of whether it makes sense for the bank to lend in that particular instance. If China wants to stimulate or prop up a certain sector of the economy, then that is what the state-owned banks will do. Even if that means that the banks may be saddled with bad loans and suffer losses in the future because of it. Not a good prospect if you own shares in that company.

What impact does the Chinese government have on bulls and bears using FXI?

The outside influence by the Chinese government can have a direct impact on a bullish or bearish stance on China using FXI. For instance, let’s say someone was bullish on Chinese oil companies because higher prices of crude oil should help increase their profits. The investor finds out at the earnings release that company profits are going down because of government-mandated price controls or price caps.

So instead of share prices going up as expected, shares go down. The bullish thesis did not work because state-owned enterprises follow government directives first and pursuit of shareholder value is of lesser importance. Anyone who is bullish on China should understand that FXI may not give them want they expect due to the presence of so many state-owned enterprises.

The reverse is also true. Anyone who is bearish on China should know that they are going up against a government that holds most of the shares in many of the companies in FXI and has very deep pockets. If you are short, then you run the risk of suffering losses caused by the Chinese government. Your bearish thesis may be sound, but the Chinese government has a way of disrupting it.

The government could, for instance, prop up any company or sector, with cash infusions that shorts will find hard to match. For example, a popular thesis on China over the years has been to be bearish on the financial sector, especially the banks. But China controls most of the banks, which is probably the reason why the bearish thesis on the financials in China has not worked out even after all these years.

The pros of FXI do not outweigh the cons

FXI does have some things going for it as an ETF. It is very liquid, which makes it easy to trade. It holds a wide array of companies that are active in several different sectors of the Chinese economy. Unfortunately, the pros of FXI do not outweigh the cons in my opinion.

FXI is no good as long as its composition stays the same. While it is true that state-owned enterprises form an important part of the Chinese economy, they do not account for the majority. Certainly not 60 percent, which is the share they hold in FXI. FXI is not a good representation of China and what drives it, which can lead to misleading results.

In particular, the presence of so many state-owned enterprises in FXI leads to performance that is not reflective of the real situation on the ground. While FXI offers exposure to China, it is not an accurate one, regardless of whether you are bullish or bearish. That is why something better is to be found elsewhere.

Source: Wikimedia Commons

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.