Big China A-Share ETF Sees Growing Pains

Investing in China’s dynamic economy has its obvious allure, but investors must understand its complexities.

The Deutsche X-trackers Harvest CSI 300 China A-Shares ETF (ASHR | D-5e), which launched in November 2013 with more than $100 million in seed capital, is now a blockbuster ETF with $511 million in assets.

Based on flows and assets, I think it’s fair to say that ASHR has become the de facto way for U.S. investors to capture China’s mainland, or A-share, market through an ETF wrapper.

But ASHR’s become so popular that it’s now limiting creations, raising concerns that the fund’s price may rise above its net asset value (NAV).

While I expect any “premium” that might develop in ASHR to likely be temporary, I do think watching for this possibility is sensible, especially for new investors.

In just two months, since mid-July, ASHR’s had more than $280 million in net inflows.

Source: ETF.com

Notice that leading up to Sept. 11, ASHR had a massive inflow of $82 million in a single day. On that day, Deutsche announced it was limiting creations in ASHR to only one creation unit per day, or 50,000 shares.

The reasoning? According to Deutsche, ASHR is nearing its renminbi qualified foreign institutional investor (RQFII) quota.

RQFII ETF Quota Limits

I talked about potential issues with RQFII quotas in a blog when ASHR first launched in November.

ASHR is an RQFII ETF capable of accessing China’s mainland market through physical shares (as opposed to derivatives), but the A-share market is still restricted to certain degrees, and these RQFII ETFs are only allotted a specific monetary quota limit.

ASHR originally launched with a quota of 2 billion RMB (roughly $326 million at today’s conversion rates). Since then, its quota has been increased to 3.63 billion RMB, or roughly $592 million.

While quotas used to be fund-specific, the rules around RQFII quotas have been relaxed over the months, and asset managers are now permitted to reallocate their quotas among their various funds.

RQFII Reallocation

I recently noticed on Deutsche’s website that ASHR’s small-cap sister fund, the Deutsche X-trackers Harvest CSI 500 China A-Shares ETF (ASHS), now has a quota of 100 million RMB. Crucially, that’s a reduction in quota.

After all, ASHS launched in May 2014 with an initial quota of 1 billion RMB. By the way, creations on this small-cap fund, ASHS, were also limited to one unit a day beginning Sept. 11.

This reduction in ASHS’ quota suggests to me that Deutsche reallocated 900 million RMB in quota from the smaller ASHS to the larger ASHR, which has seen a surge in flows over the past few months.

That said, the remaining 730 million RMB may possibly have come from an increase in quota, and here’s why: Remember that ASHR’s current quota is 3.63 billion RMB, and ASHR’s 2 billion RMB initial quota plus 900 million from ASHS equals only 2.9 billion RMB.

ASHR’s prospectus clearly states that in the event its quota is reached, Deutsche can limit or halt creations or use futures contracts and derivatives until more quota is granted. To be perfectly clear, for now, Deutsche has limited creations.

Ball In Chinese Government’s Court

Unfortunately, RQFII ETFs are at the mercy of China’s State Administration of Foreign Exchange (SAFE) to obtain additional quota. Exactly when SAFE will grant additional quotas is anyone’s guess. It can be days, weeks or months from now.

To be clear, Deutsche hasn’t yet announced a full creation halt. But limiting creations is what we call a “creation impediment” here at ETF.com. What this means is that the ETF is no longer fully able to create shares as needed in a timely manner.

Even “impediments” to creations can potentially cause an ETF to trade at a premium to its NAV, even if it’s just temporary.

ASHR’s one-creation unit limit—again, 50,000 shares—means it’s limited to roughly $1.28 million a day in creations (at current NAV), which isn’t much based on the types of flows we’ve seen into ASHR in recent weeks.

The Takeaway

To be clear, even if ASHR hits its quota, it doesn’t necessarily mean the fund has to halt creations. In such an event, I suspect the fund will have several options to continue creations to avoid any large premiums from developing.

For example, ASHR could begin using FTSE China A50 Index futures contracts traded in Singapore in the interim to meet investor demand. This option wouldn’t be ideal over a long period of time because that could cause slippage from tracking the CSI 300 Index, but it would be a workable stop-gap measure.

I also wouldn’t be surprised if any creation issues with ASHR end up being temporary. I still own shares in ASHR, and don’t plan on making any changes simply due to this creation limitation.

Still, if China’s A-share market continues its hot streak and the Chinese regulator, SAFE, continues to drag its feet in granting additional quotas for whatever reasons, I think it makes sense for investors to be aware of the possibility of a premium developing. That means they’ll have to be mindful of the price they’re paying for the ETF shares relative to NAV.

I realize that NAVs for international ETFs like ASHR are often stale during trading hours because there’s no overlap in market hours between China and New York, causing minor divergences from share prices on a regular basis. But monitoring the fund’s NAV can still be helpful in noticing major divergences from share prices.

ASHR’s recent creation limitation reminds us that China investing comes with complexities, and it continues to make sense to keep track of changes in this constantly evolving market.

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