China A-Shares No ETF Game Changer

China A-shares in a broad emerging market fund may be the right idea at a terrible time.

Plans to bring to market the KraneShares FTSE Emerging Markets + All China ETF are interesting in one sense but ill-fated in another. Here’s why.

Just like adding a superstar to a team doesn’t make it an automatic contender, adding China A-shares to a broad emerging market fund, in my opinion, is no game changer for investing in the developing world.

In other words, the design of KraneShares’ new fund is interesting and potentially useful for passive investors. But the timing could hardly be worse.

What I mean is that this KraneShares fund is likely to come to market at a time when investors are pulling record amounts of money from broad emerging market funds like the iShares MSCI Emerging Markets ETF (EEM | B-100) and the Vanguard FTSE Emerging Markets ETF (VWO | C-89).

According to the preliminary filing detailing the KraneShares FTSE Emerging Markets + All China ETF, the fund will track a new FTSE index that includes both traditional emerging markets investing exposures as well as the China A-share market—arguably the holy grail of China equity investing.

(For a full appreciation of the complexity of China’s equity market, refer to ETF.com’s “The Complete Guide To Chinese Share Classes.”)

The Good News

So, first, let’s start with the positives.

Using ETF.com’s ETF Analytics to see country exposure in the two largest broad emerging market funds, EEM and VWO, leads to a quick and clear conclusion: China is quite underrepresented.

To be clear, despite being the second-largest economy globally, China occupies less than 20 percent by weight in either EEM’s or VWO’s portfolio.

This phenomenon is largely due to strict capital control imposed by the Chinese government—the domestic Chinese equity (A-shares) market is still largely inaccessible to foreign investors.

Because many large Chinese companies are listed solely in the A-share market, indexes that exclude the A-share market don’t quite provide an accurate representation of the larger Chinese equity market.

Thanks to the recent expansion of the renminbi qualified foreign institutional investors (RQFII) program—U.S. investors finally have direct access to the Chinese A-share market via U.S. listed ETFs—the db X-trackers Harvest CSI 300 China A-Shares Fund (ASHR) and the Market Vectors China AMC A-Share ETF (PEK | F-46).

However, investors looking for broad-marketlike EM exposure are still left unsatisfied by existing broad emerging market ETFs. Here comes KraneShares FTSE Emerging Markets + All China ETF.

The fund will track the FTSE Emerging + China All Share Class Index, which expands the existing FTSE Emerging Index by adding China A-Shares.

By leveraging its existing relationship with Bosera Asset Management in Hong Kong, KraneShares will have access to RQFII quota, hence access to the highly restricted and coveted A-share market. As such, the fund can track a more inclusive emerging market index.

This is good news for passive investors looking for broad and representative emerging market exposures.

Rather than holding EEM or VWO and adding some long positions in ASHR, investors can get broader and more diversified emerging market exposures by holding only one fund. It’s quick and easy.

Doomed To Fail?

If the KraneShares fund sounds like it’s too good to be true, it might be because it is. As I said, here’s why:

Despite the good design, the timing looks rather poor. I’m not sure if there’s investor appetite for another broad emerging market fund now.

Let’s face it: The broad emerging markets bull market is long gone. Emerging markets no longer perform as a homogenous unit.

There are problem countries and countries with sound foundations, as the table below shows.

The single-market funds I looked at were selected using ETF.com’s “Analyst Pick” designation, which measures objective variables such as most-marketlike exposure in a given segment relative to broad benchmarks.

The table above adequately presents divergence in country performance.

Over a five-year horizon, Brazil is the biggest laggard, while Taiwan has been slow and steady.

Advocates of passive and index investing will argue this is precisely why a broad and well-diversified emerging market fund is better; offsetting performance by countries will reduce single-country concentration risk.

However, others—myself included—will argue that now is not the time to go broad. Rather, the time is ripe to go granular and differentiate the strong countries from the weak ones.

A quick flow analysis with ETF Fund Flows shows that other investors seem to agree with me.

EEM and VWO experienced massive outflows in 2013, while single-country funds such as the iShares MSCI Mexico Capped ETF (EWW | B-94) and the iShares MSCI India ETF (INDA | C-97) had strong inflows.

It’s important to recognize that outflows from EEM and VWO can be a simple function of investors shifting exposure these days to developed markets or other asset classes.

However, my point remains that investors are reducing their broad emerging markets exposures while picking apart the space and adjusting country-specific exposure in a more targeted and strategic manner.

China A-Shares Are No Game Changer

Adding Randy Moss to the Raiders that did not result in a material difference. Similarly, adding A-Share exposure to a broad emerging market fund, in my opinion, is not a game changer for broad emerging market investing.

As our very own Matt Hougan has put it in a CNBC interview during ETF.com’s 7th Annual Inside ETFs conference, “emerging markets is a disaster.” I’m just not sure if adding China A-shares is sufficient to make a broad emerging market fund a winning bet.

China has its own economic challenges: aging demographics; high level of inflation; potential crisis caused by its shadow-banking system. The A-share market has been down by about 13 percent in the past year.

As such, I’m bearish on emerging markets, but see pockets of value in the space that can be captured only by deviating from a broad market investing approach.

At the risk of repeating myself, the bottom line is this: The KraneShares FTSE Emerging Markets + All China ETF is an interesting filing that provides investors a better broad EM exposure.

It can certainly be a very nice core EM-holding building block.

However, I’m not sure if investors have appetite left for another broad EM fund, as the record outflows from broad emerging market ETFs clearly show.

At the time this article was written, the author held a long position in ASHR. Contact Howard Lee at [email protected].