A Different Perspective On CAF

September 29, 2009

Matt Hougan's article on Morgan Stanley's closed-end China fund only tells half the story on whether or not domestic Chinese equities are truly overpriced.

Matt points out that as a closed-end fund, Morgan Stanley China A-Share Fund (NYSEArca: CAF) currently trades at a premium. In addition, the Shanghai-listed Chinese A-shares that the fund invests in also trade at a premium, compared with equivalent shares listed abroad. Add it together and CAF ends up being 18 percent more expensive than a basket of similar Chinese company shares listed in Hong Kong or
New York

In other words, you are paying nearly a fifth extra for the hope that other international investors will, over time, attempt to flock to
Shanghai. (Read the whole story here.)

For Matt, that’s too high a price for what seems like an outright gamble. There are few who would disagree.

The A-share premium ultimately works like initial repayments in a Ponzi scheme. If
China opens up its domestic exchange to international investors, that premium will likely collapse.

But that might not happen for a long, long time. And in the meantime, the premium depends on what price investors in the domestic markets are willing to pay each other. As such, that’s the way I think you have to judge any investment in CAF.

I don’t think it’s very useful to use a year-to-date, or even 12-month, time horizon for CAF. This was a period of dynamic readjustment in global equity prices, where markets were more or less insularly focused.

Instead, mark the time horizon for the fund back five years, and compare the results with other China-related ETFs. When you do that, you can see that CAF easily beats competing ETFs such as GXC and FXI in terms of percentage-point gains.

Indeed, up until the beginning of the market fallout in late 2007, CAF was more than three times ahead of these two.

This was a period when
was implementing all sorts of new foreign-investor-based programs; there was also plenty of cheap money to channel into them. That hasn’t been the case this year.

’s various qualified foreign institutional investor (QFII) quotas, only one bank (UBS) was at its $800 million maximum investment limit earlier this year (it has recently been expanded to $1.2 billion). The rest have around $400 million or less invested in the mainland through the program.

Placing a bet on CAF then is not just placing a bet on China; it’s placing a bet that foreign institutions will throw more cash
’s way. Judging from all the various trading notes I’ve seen recently citing emerging markets as the big profit area going forward, I think that’s a plausible scenario.

As banks become better capitalized again, and if
decides to keep most of its domestic market closed to foreign investors (extremely likely), there will be all sorts of creative ways in which firms try to get in the back door. That, in turn, will mean mainland equity prices begin to skyrocket.

So if you think loose global monetary policy will end up channeling much of today’s greenbacks eastward, CAF could well present a viable investment opportunity right now.



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