As I’ve said recently, the Chinese interference in the A-share market has fundamentally broken things for U.S. investors. Many of the interventions will just play out in the inefficient allocation of capital—the lockups on institutional shareholders, the rigorous use of debt to finance equity purchases, etc.
But for U.S. investors actively playing the situation in China, there’s a much more fundamental problem: the trading locks. China has simply—seemingly almost at random—closed various A-shares for trading.
As a U.S. investor who is not actually on the ground in mainland China, this leads to significant information gaps. Nowhere is this more evident than in the Deutsche X-trackers Harvest CSI 500 China-A Shares Small Cap ETF (ASHS | F-67).
Great Option To Have
To start with, let me say that I love this ETF. It scored poorly in our system (F-67) because it’s expensive, at 80 bps, and hasn’t tracked its index perfectly. But I love that the fund exists as an option for the adventurous international investor. It directly holds the 500 smallest-cap stocks listed in mainland China, which turn out to be not that small: The weighted average market cap is more than $3 billion. Most of the portfolio would firmly be considered midcap by U.S. standards. In other words, despite the name, these are not fly-by-night penny stocks.
However, to halt the decline in the local markets, China has locked a host of these firms—which are current holdings of ASHS—out of the market, and in some cases, since since 2014.
The last recorded trade in Ningxia Zhongyin Cashmere Co., Ltd. Class A (000982-CN) was Aug. 22—11 months ago. More typically, a ton of stocks were suspended in from trading back in May, leading to more than 100 charts from the portfolio that look like this, top holding Eternal Asia Supply Chain Management (002183-CN):
And yet these stocks remain in both the CSI 500 Index and ASHS.
This completely breaks any ability for investors to really understand the “fair” price of their holdings in ASHS.
Breaking It Down
First, let’s take a look at what’s happened with ASHS here in the U.S. over the last month:
The first point I’d make is that ASHS has held up surprisingly well here. Volumes, while not stellar, are averaging more than 100,000 shares a day, making it entirely tradable for most investors. And in general, the price you pay for the ETF in the market has actually born a strong resemblance to what’s being reported as “net asset value.” Most of the time, you would expect—even in a normal market—that your international ETF actually wouldn’t track its own NAV all that well, because of the difference in time zones.
ASHS, however, is one of a class of ETFs that use “fair market value” practices in calculating NAVs. From their prospectus:
“If a security’s market price is not readily available or does not otherwise accurately reflect the fair value of the security, the security will be valued by another method that the Adviser believes will better reflect fair value in accordance with the Trust’s valuation policies and procedures approved by the Board. “
That means that even though some of these stocks haven’t traded in almost a year, the fund calculated a “best guess” based on comparable stocks and indexes that are trading. This is a very good thing, generally speaking (and how the entire bond market deals with pricing as well). It’s a very, very good thing when it comes to a crazy, half-closed, less liquid market like China A-share small-caps.
So what happened in the middle of July, when the traded price of the ETF differed significantly from the fair-valued NAV reported by ASHS?
Two things. First, the premium coincided with the maximum number of securities in the portfolio being closed:
On the July 9, less than half of the portfolio in ASHS measured by weight was actually trading. That made the NAV being reported particularly hard for anyone other than the fund's accountants to be sure of, which makes it particularly hard for authorized participants to step in and arbitrage out any differences.
The second point is that this was going on precisely when the shorts were having a field day. Based on Markit’s excellent short data, the spike in premium and collapse in underlying tradability coincided with the height of short-selling.
The story here—maybe—is that short-sellers saw the “irrational” high price as the trading price of ASHS bounced from $37 on July 8 to $53 on July 10, and pounced to take advantage. Of course, to put that big a short on, you have to be able to borrow it. The evidence would suggest that the APs were more than happy to step in, create new shares and loan them to the shorts for a pretty penny (ASHS has the most expensive rating for borrowing costs by Markit).
And once the trade started paying off and the premium collapsed, the shorts left, and APs redeemed those shares back into Deutsche, shown here happening on July 13.
The Moral Of The Story
First, I want to acknowledge that forensics like this are really squishy. Both short-reporting and flows-reporting can be subject to lags, which are often impossible to tease out. My suspicion here is that the flows numbers we’re calculating are lagged by one day, which is actually the norm for flows reporting. That would put the creations happening more cleanly with the highest shorting, and the redemptions happening right when the short interest collapsed.
But importantly, at a micro scale, these kinds of transactions happen all the time. ETFs trade to slight premiums and discounts, short-sellers and APs look for short-term opportunities, and ETFs trading prices snap into fair value.
Broken Market Consequence
The reason these charts look so dramatic is because the underlying market is broken, so moves and gaps that normally happen in pennies in basis points happen in dollars and percentages.
And the coolest part is that this is evidence of the ETF structure doing exactly, precisely and beautifully what it’s intended to do. Just as the underlying market went to pot, the ETF became a price-discovery vehicle.
Once that happened, a whole raft of market participants stepped in to actually contribute—the short-sellers were part of it, the APs were part of it and yes, the enthusiastic buyers who drove the price of ASHS from $37 to $53 were part of it too.
And once the underlying market became, once again, at least slightly more liquid, the ETF snapped right back in line to advertised fair value.
At the time of this writing the author held no positions in the securities mentioned. Dave Nadig is the director of exchange-traded funds at FactSet Research Systems. You can reach Dave at [email protected], or on Twitter @DaveNadig.