Alibaba IPO’s Huge ETF Conundrum

September 15, 2014

Where ETF investors can find Alibaba shares is no simple matter.

Alibaba, China’s e-commerce juggernaut, is set for a historic IPO later this week, but many questions have been raised regarding how the newly public company will be placed in ETFs.

The issue with Alibaba, regarding index placement, deals with its incorporation in the Cayman Islands and its U.S. listing.

Basically, according to the methodologies of indexing giants like MSCI and FTSE, a stock like Alibaba becomes “country-less” and falls into no-man’s land.

MSCI looks at a company’s country of incorporation and primary listing for country assignment. Meanwhile, only Hong Kong-listed Chinese shares and “B shares” are eligible for inclusion into FTSE’s Global Equity Index Series. U.S.-listed China N-shares are not eligible. (For a deeper read on China share classes, see our 2014 China ETF Guide).

This makes Alibaba shares ineligible to be held in some of the largest ETFs in the world, including the $50 billion Vanguard FTSE Emerging Markets ETF (VWO | C-90) and the $44 billion iShares MSCI Emerging Markets ETF (EEM | B-98).

In a strange twist, looking beyond emerging and China-specific ETFs, Alibaba’s decision to list on the NYSE instead of Nasdaq also makes it ineligible for inclusion into the $47 billion PowerShares QQQ ETF (QQQ | A-46).

The exclusion of Alibaba from most MSCI- and FTSE-based ETFs has some big implications from the perspective of Alibaba shares and ETF investors, since the lion’s share of assets in emerging market ETFs are tied to MSCI and FTSE-based indexes.

Much has been written about how Alibaba’s variable interest entity structure (VIE) is keeping it out of these indexes. But the issue isn’t solely Alibaba’s VIE structure. It’s Alibaba’s VIE structure and that it its shares will only be listed in the U.S.

For example, Tencent Holdings, China’s largest Internet company, is also incorporated in the Cayman Islands and uses a VIE structure. But because it lists its shares in Hong Kong, it passes as a P-chip, making it eligible in MSCI’s and FTSE’s emerging markets and China indexes.

So what does all this mean?

 

First, this potentially has implications for Alibaba shares, since there are several hundred billions of dollars in assets tied to index funds (and ETFs) globally.

According to MSCI, there was about $210 billion in assets from passive index funds tied to its emerging markets indexes as of May 2014. Most of these funds won’t be eligible to purchase Alibaba shares.

How that will ultimately impact the shares over the long term is difficult to predict. You’re basically trying to predict demand for Alibaba shares months from now, since most of these broad indexes take months for shares issued in an IPO to be included anyway.

That said, I think it’s fair to say that it’s somewhat of a hurdle for Alibaba shares. If it listed in Hong Kong, there would have been additional hundreds of billions of dollars in passive fund assets waiting to purchase the shares in the coming months (of course in proportion to the shares’ appropriate weighting within the funds, mostly determined by free-float market-cap).

Secondly, ETF investors are impacted because they are shut out from exposure to some of China’s fastest-growing, entrepreneurial companies (Chinese e-commerce and e-tailing), raising the question of whether ETF investors are truly getting full coverage of the broad Chinese equity market.

Looking beyond broad emerging market ETFs, it’s unfortunate that investors in China-focused ETFs like the $6 billion iShares China Large-Cap ETF (FXI | B-51) and $1.1 billion iShares MSCI China ETF (MCHI | B-43) aren’t fully getting exposure to the “best of China.”

This issue reaches far beyond just Alibaba. I’ve harped on this for a while, but basically all U.S.-listed Internet companies are ineligible in the above-mentioned funds. This includes Baidu, SINA, Weibo, JD.com, NetEase … the list goes on.

Interestingly, only last week, MSCI suddenly announced it would begin consultation on potentially including these offshore incorporated Chinese companies, or N-shares, in its Global Investable Market indexes.

I don’t think the timing of this announcement is a coincidence. I can only imagine how many phone calls and inquiries MSCI must be getting about Alibaba’s inclusion in its indexes.

So which ETFs will include Alibaba?

 

The key is to scope out ETFs that allow the inclusion of China “N-shares.” With regard to major global indices, that means sniffing out ETFs based on S&P emerging markets indexes, since the S&P BMI indexes include N-shares.

Immediately coming to mind within the China space is the $983 million SPDR S&P China ETF (GXC | B-43) and the PowerShares Golden Dragon China ETF (PGJ | A-23). GXC is a comprehensive “offshore” China ETF, while PGJ is only eligible to hold U.S.-listed N-shares.

For those looking for quick access to Alibaba in a China-specific fund, your best bet will probably be the KraneShares CSI China Internet ETF (KWEB | B-23), which just surpassed the $100 million in assets mark. According to KraneShares’ website, Alibaba could be added to KWEB as soon as 11 days after its IPO.

I’ve put together the three largest emerging market ETFs and the three largest China ETFs that should be, and likely won’t be, eligible to include Alibaba:

Top 3 Eligible EM ETFs AUM ($M)
*ECON - EGShares EM Consumer 1,330
**FEM - First Trust EM AlphaDex 468
GMM - SPDR S&P EM 275
*Depending on classification outcome
**Depending on AlphaDex methodology

 

Top 3 Ineligible EM ETFs AUM ($M)
VWO - Vanguard FTSE EM 50,290
EEM - iShares MSCI EM 43,920
IEMG - iShares Core MSCI EM 5,610

 

Top 3 Eligible China ETFs AUM ($M)
GXC - SPDR S&P China 983
PGJ - PowerShares Golden Dragon China 310
KWEB - KraneShares CSI China Internet 103

 

Top 3 Ineligible China ETFs AUM ($M)
FXI - iShares China Large Cap 5,940
MCHI - iShares MSCI China 1,160
ASHR - DBX Harvest CSI 300 China A-Shares 434

 

 

 

 

 

 

 

 

 

 

Note: This should only be used as a guide, as methodologies can change in the coming months.

 

Finally, it’s worth pointing out that GICS has assigned Alibaba to the consumer discretionary sector, not information technology. This might have implications for funds like the $78 million Guggenheim China Technology ETF (CQQQ | C-25), which uses GICS for sector classification purposes.

Meanwhile, it’s possible Alibaba can show up in consumer-related emerging market ETFs, depending on which sector classification is used for their underlying indexes.

Immediately coming to mind is the $1.3 billion EGShares Emerging Markets Consumer ETF (ECON | C-38), which uses ICB’s classification. As of this writing, I haven’t been able to confirm ICB’s sector classification of Alibaba.

In conclusion, Alibaba’s choice to list in New York instead of Hong Kong so that its founders can hold onto more control of the company makes Alibaba shares ineligible for inclusion into the 4th-, 5th- and 7th-largest ETFs in America (VWO, QQQ and EEM, respectively), which total $141 billion in assets, combined.

That said, I think Alibaba’s IPO is ultimately good for ETF investors as a whole. It’s finally bringing to light the complexities around China share classes, and how they impact indexes and the associated ETFs.

I believe, at the end of the day, this will only lead to investors making better investment decisions around China ETFs.


At the time this article was written, the author held a long position in ASHR. Contact Dennis Hudachek at [email protected], or follow him on Twitter @Dennis_Hudachek.

 

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