What’s In Your China ETF?

September 19, 2011

Not all China ETFs are created equal, and investors should be asking what type of shares their China funds hold.

More than 20 China-focused ETFs are now on the market that range from size and style funds to sector-specific ETFs. But because China has a state capitalist system with investment restrictions, numerous share classes of Chinese shares exist—some of which are available for foreign ownership and some that aren’t.

ETF investors stand to benefit in knowing the differences between A, B, H and N shares, since some ETFs hold only one type of Chinese shares, while others hold an assortment of them.

Let’s start with A-shares. A-shares represent mainland Chinese companies that trade on the Shanghai or Shenzhen exchanges. Most importantly, foreigners are restricted from investing directly in A-shares. Currently, only qualified foreign institutional investors (QFII) that are approved by the Chinese government are permitted to purchase A-shares.

H-shares represent mainland Chinese companies that trade on the Hong Kong Stock Exchange. Many companies float their stocks on the mainland market as A-shares, and as H-shares in Hong Kong. H-shares are open to foreign investors and constitute the bulk of holdings in many China ETFs.

B-shares represent mainland Chinese companies that trade in Shanghai or Shenzhen and are settled in foreign currencies. B-shares traded in Shanghai are settled in U.S. dollars, while B-shares traded in Shenzhen are settled in Hong Kong dollars. B-shares are also open to foreign investors.

N-shares represent Chinese companies that trade on a major U.S. exchange. Some Chinese companies, such as Baidu and NetEase, only float their shares in the United States, while others like China Mobile also float ADRs in the U.S.

To show how different the composition of some of the most popular China ETFs can be, let’s take the iShares FTSE China 25 Fund (NYSEArca: FXI) as an example. FXI is a beast of a fund, with over $6 billion in assets under management, but it actually only holds 25 of the largest and most liquid H-shares—hardly a representation of the entire Chinese market.

For the average investor looking for total market exposure, a better choice might be a fund like the SPDR S&P China Fund (NYSEArca: GXC), which holds all investable Chinese shares. GXC holds 157 companies, and is currently the second-largest China fund, with $720 million in assets. Another fund with similar exposure to GXC is the Guggenheim China All-Cap Fund (NYSEArca: YAO).

But most importantly, because these funds hold all investable Chinese shares, they provide investors with the most diverse exposure to the entire Chinese equity market; after all, it’s tough to argue that certain companies that only trade in the States, like Baidu and Sina, are not important players in the Chinese economy.

Some China ETFs only hold U.S.-listed companies (N-shares), such as the PowerShares Golden Dragon Halter USX Fund (NYSEArca: PGJ). While the fund holds 196 companies, it lacks exposure to many important Chinese companies not listed in the United States, including Bank of China and Tencent Holdings.

Last fall, investors cheered the launch of the first China ETF with exclusive exposure to A-shares. The Market Vectors China Fund (NYSE Arca: PEK) aims to track the CSI 300 Index, which consists of 300 A-share stocks listed on the Shanghai or Shenzhen exchanges.

PEK doesn’t actually hold A-shares, but gains exposure to A-shares through a swap agreement with a QFII—in this case, Credit Suisse Securities. This means PEK comes with counterparty risk. Investors should also be aware that PEK has historically traded at a premium because access to the A-share market is still limited.

As a testament to investor demand for Chinese stocks, there are now over 25 China ETFs in registration with the Securities and Exchange Commission. These include another swap-based A-shares fund from BlackRock, as well as 12 sector-specific funds from Van Eck Securities.

As these new funds launch, investors should continue to be aware of their share exposure. By understanding Chinese shares and the risks associated with certain funds, investors will be better prepared to decide which fund is suitable for their investment objectives.


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