China ‘Stock Connect’ To Impact Many ETFs

A new program linking exchanges in Hong Kong and mainland China will have far-reaching consequences.

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Senior ETF Specialist
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Reviewed by: Dennis Hudachek
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Edited by: Dennis Hudachek

A new program linking exchanges in Hong Kong and mainland China will have far-reaching consequences.

It’s official, the historic Shanghai-Hong Kong “Stock Connect” program will commence on Monday, Nov. 17.

The Stock Connect will link the Hong Kong and Shanghai Exchanges to allow investors cross-exchange trading up to daily and aggregate quota limits.

Investors have largely focused on one marquee China A-share ETF in connection with the new program, but it has bigger implications for China’s entire equity and fixed-income markets and their respective ETFs.

ASHR’s Close-Up

The $444 million Deutsche X-trackers Harvest CSI 300 China A-share ETF (ASHR | D-55) has taken center stage ever since the “Stock Connect” was first announced in April. ASHR was the first physically backed, “RQFII” ETF to launch in the U.S. and tracks the mainland’s benchmark CSI 300 Index.

ASHR’s gotten the lion’s share of inflows for A-share funds, netting more than $262 million since May 1. ASHR got so hot at one point that Deutsche X-trackers had to limit creations to 1 unit per day in September because the fund was brushing up against its quota (the limit has since been increased to 10 creation units per day).

Since May 1, ASHR has gained more than 22 percent as investors rushed into A-shares in anticipation of the Stock Connect and on optimism over recent reforms around China’s state-owned enterprises (SOEs).

Ashare Performance

Note: ASHS launched on May 21, 2014

Chart courtesy of StockCharts.com

 

Beyond ASHR

Still, a lesser-known A-share ETF, the $22 million Deutsche X-trackers Harvest CSI 500 China A-Shares Small Cap ETF (ASHS), performed even better. ASHS captures the bottom 500 “small-caps” from the broader CSI 800 Index, and complements the 300 “large-caps” held in ASHR.

ASHS is an interesting play, because it taps many more consumer-related sectors than ASHR, which remains top heavy in SOEs, mainly from the financial sector.

ASHR (CSI 300)ASHS (CSI 500)
Financials389.2
Industrials13.225.2
Consumer Cyclicals10.716.5
Basic Materials7.615.9
Consumer Non-Cyclicals7.66.8
Technology7.011.3
Health care6.58.8
Energy4.73.5
Utilities3.82.8

 

 

 

 

 

 

 

Source: ETF.com

The caveat here is that ASHS is now trading at a trailing P/E of 32.04, compared with ASHR’s trailing P/E of 10.77. Low valuations are one factor attracting investors to A-shares, but when it comes to ASHS, you’re now paying a hefty price to access this untapped small-cap market.

Hong Kong-Listed ETFs

Remember that the Stock Connect is also a two-way street between Shanghai and Hong Kong. This means mainland investors formerly restricted from investing in HK-listed Chinese companies can now access the Hong Kong market.

Mainlanders may be itching to get a piece of some “jewels” of the Chinese economy only listed in Hong Kong, such as Tencent Holdings, China Mobile and CNOOC. This could bode well for ETFs targeting HK-listed Chinese firms like the $1.2 billion iShares MSCI China ETF (MCHI | B-38) and the $5.6 billion iShares China Large Cap ETF (FXI | B-52).

 

Shenzhen

Looking ahead, assuming the Stock Connect is successful, Shenzhen is clearly the next logical exchange for a future Connect program.

Many investors are excited about Shenzhen-listed shares because they’re tilted more toward consumer- and tech-related companies poised to benefit from China’s grand plans to reorient their economy toward a consumption-based model in the coming years.

While the current program only connects Hong Kong with Shanghai, the Stock Connect should free up quota for current RQFII licensed firms, which can use that additional quota to tap Shenzhen shares.

Quota reallocation is an important concept to grasp, because issuers are now permitted to reallocate quotas between their various funds.

Keep in mind that Shenzhen securities currently make up roughly one-third of the CSI 300 Index and about half of the CSI 500 Index, by count.

The only Shenzhen-specific ETF at the moment is the $15.8 million Market Vectors ChinaAMC SME ChiNext ETF (CNXT). The recently launched CNXT goes beyond simply offering Shenzhen shares—it specifically targets small and medium-sized enterprises by holding 100 of the largest companies on Shenzhen’s SME and ChiNext Boards.

This makes CNXT rich in “new economy” sectors like technology and consumer discretionary, offering a next-gen take on China’s plans to transform its economy. According to Van Eck, the two sectors account for more than 40 percent of the fund’s weighting, combined.

Mainland Bond ETFs

Issuers can also reallocate their quotas across funds in different asset classes, meaning the Stock Connect should free up additional quota for issuers to tackle the fixed-income space.

Just today, Van Eck broke new ground in launching the first U.S.-listed mainland Chinese bond ETF. The Market Vectors ChinaAMC Bond ETF (CBON) is an aggregate bond ETF targeting a broad basket of mainland issued Chinese bonds.

Mainland bonds offer plumpy yields, especially at the shorter end of the yield curve. For example, one-year Chinese government bonds (CGBs) currently yield about 3.2 percent. Just to put things into perspective, one-year U.S. Treasurys are currently yielding 0.12 percent.

According to Van Eck, CBON has a yield to maturity of 4 percent, even though 70 percent of the portfolio is weighted in maturities less than three years, giving the fund an average portfolio maturity of only 2.05 years.

China-specialist KraneShares is also expected to launch a pair of currency-hedged and unhedged China commercial paper ETFs expected for launch in the near future, so it looks like we’ll be getting more innovation from China’s domestic bond market soon.

Looking Ahead

It’s hard to know exactly when the barriers will fully come down in China’s restricted markets, but they’re clearly moving toward liberalization, going from the QFII, to the RQFII and now the Stock Connect program. I doubt the Stock Connect will be the last step in this multiyear process.

I see the Stock Connect as huge step for China’s mainland markets. The Stock Connect impacts markets beyond Shanghai stocks and should benefit Shenzhen- and Hong Kong-listed securities, as well as China’s untapped $5 trillion onshore bond 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.

 

Dennis Hudachek is a former senior ETF specialist at etf.com.