On July 17, PGJ, the 4th-largest China ETF by assets, fell more than 4 percent, while its competitors—FXI, GXC, and MCHI—posted positive gains for the day. What happened?
China's had its share of weirdness in 2012. For example, on the 23rd anniversary date of the Tiananmen's Square Massacre, the Shanghai Composite fell 64.89 points, an ominous number pointing to the exact date of the actual event, which occurred on June 4, 1989.
While some things can't be explained, the staggering difference in returns a few weeks ago between the PowerShares Golden Dragon China Portfolio (NYSEArca: PGJ) and its competitors is explainable.
The PGJ sell-off was originally triggered by the announcement on July 17 by Chinese private education leader New Oriental Education (NYSE: EDU) that the SEC was investigating its accounting practices.
That day, EDU fell 34.3 percent. PGJ had a 5.4 percent weighting in EDU that morning, so naturally, this would affect the fund's performance. Still, PGJ fell by more than 4 percent—a bit steep for a sell-off in a single 5.4 percent holding. So, there's more to the puzzle than meets the eye.
I've recently blogged about the importance of understanding Chinese share classes in ETFs. While my most recent blog discussed the shortcomings of the iShares FTSE China 25 Index Fund (NYSEArca: FXI) and the iShares MSCI China Index Fund (NYSEArca: MCHI), PGJ is another great example to discuss.
Simply put, the real culprit behind PGJ's big fall lies in its index methodology and its exclusivity to holding only U.S.-listed Chinese shares, or N-shares.
The Story Behind N-shares
Many Chinese companies engaged in sectors like Internet, media and education, list their shares in the U.S. using a variable interest entity (VIE) structure to circumvent restrictions on foreign direct investment.
N-shares have been a hot topic in recent years because of investor concerns over the somewhat-murky regulatory and legal issues surrounding this VIE structure.
Details of the structure are complex, but in a nutshell, many Chinese companies set up holding companies in foreign jurisdictions (usually in tax havens like the Cayman Islands) and float those shares in the U.S.
The actual operating companies in China (the VIEs), maintain the business licenses and are usually owned by a select few executives—sometimes just the founder. Through contractual agreements, the shareholders and the executives agree to share in the profits of the operating companies.
Many companies have used this structure to list in the U.S., including popular names like Baidu, Sina, NetEase and New Oriental Education. Still, the Chinese government has never actually addressed the legality of this VIE structure and has so far turned a blind eye to it.
Now there's increasing speculation about whether the Chinese government (and/or the SEC) will crack down on this structure and tighten regulation on VIEs.
The SEC's investigation of EDU likely spooked investors in other N-shares. That day, not only did EDU fall, but so did many other heavily weighted N-shares in PGJ's top holdings.