Investing In The 'New China' With ETFs

Investors can take full advantage of China’s next stage of growth with a number of old and new ETFs.

[Editor's note: This is the second part of a previous blog, where I introduced the idea of rethinking China ETFs as the country transitions from an export- to a consumption-led growth model and issuers launch innovative new ETFs.]

Last month, I discussed the need to rethink China ETFs, as new and innovative products now target pockets of the Chinese markets that only a few years ago were inaccessible to global investors.

This week, I’m going to highlight a few alternative ETF options to the older veterans, positioned to target China’s ongoing market transformation.

I see two major shifts occurring in China’s equity markets in the coming years.

The first is the globalization of China’s mainland market, or the opening up of China’s onshore, or “A-share” market to global investors and indexes.

The second is the rise of the Chinese consumer. In the coming decade, a different set of companies could lead China’s next growth phase, instead of the major state-owned enterprises (SOEs) that powered China over the past few decades.

Therefore, as a China investor, I ask myself two questions: Does it still make sense to ignore China’s $3 trillion onshore market (roughly 50 percent of China’s total equity market)? Does it make sense to diversify outside of indexes that are overly concentrated in China’s SOEs that dominate the financial, energy and telecom sectors?

Onshore Market Globalization

While the recent surge in China’s mainland markets is likely due to a series of announcements around SOE reforms, China’s onshore market could remain in play for several years.

China is now in the midst of opening its mainland shares to global investors through a series of programs, dishing out renminbi qualified foreign institutional investor (RQFII) quotas left and right. Beyond Hong Kong, several other cities are now RQFII hubs, with many more likely to come.

The gradual inclusion of A-shares into some of the most widely tracked indexes will also be a multiyear process. MSCI, S&P and FTSE are all reviewing A-share inclusion into their global indexes.

I personally like that mainland securities are less correlated to global equity markets, mainly because they are still largely off limits to global investors. This offers diversification benefits.

Three-Year Weekly Correlations

Source: Bloomberg

According to this correlation matrix, the CSI 300 Index has a correlation of only 0.099 to the S&P 500, and a correlation of 0.532 to the S&P China BMI Index (which has a 0.529 correlation to the S&P 500).

Currently, A-shares are also trading at a steep discount to H-shares, according to the Hang Seng China AH Premium Index. The last time I checked, the index was at 93.22 (100 indicates parity), indicating a steep A-share discount.

Source: Bloomberg

Yet the Hong Kong-Shanghai Connect program, slated to begin in mid-October, might lead to arbitraging activity, making premiums/discounts between the markets a thing of the past.

A-Share ETF Offerings

For A-share enthusiasts, currently the largest and most liquid RQFII ETF is the Deutsche X-trackers Harvest CSI 300 China A-Shares ETF (ASHR | D-51), which launched with much fanfare last November with more than $100 million in seed capital.

ASHR tracks the popular CSI 300 Index, China’s equivalent of our S&P 500 Index. For 82 basis points, or $82 for every $10,000 invested, ASHR tracks 300 of the largest and most liquid companies traded on the Shanghai and Shenzhen exchanges.

The fund now has more than $310 million in assets and trades close to $4.5 million at 9 basis point spreads. (ASHR’s original quota of RMB 2 billion looks like it was recently increased to RMB 2.85 billion ($462 million), suggesting flexibility in its ability to raise its quota—a great sign.

A smaller, less liquid fund providing a similar take on A-shares is the KraneShares Bosera MSCI China A-Share ETF (KBA). It’s wider in scope than ASHR, holding 441 large- and midcap stocks. The $3.3 million fund currently trades only $30K a day, at 14 basis point spreads.

My colleague Howard Lee wrote a piece on KBA not too long ago. While KBA’s off to a slow start, I wouldn’t rule it out if and when the A-share market gets hot again, which could bring liquidity and assets to the fund.

China’s Rising Consumer

It’s no secret that Chinese leaders are now envisioning a transition from an export- and investment-led model to a consumption-led one.

According to one McKinsey & Co. report, “mainstream” consumers, which McKinsey defines as consumers with incomes of over RMB 106,000 (roughly $17,200), will surge to roughly 400 million people by 2020.

It’s no slam dunk that they’ll be successful, and this theme looks like it’s recently hit a snag with growth slowing. But it does look like the leadership is fully committed to this change over the long haul.

For investors wanting to hone in on this consumer theme, overweighting consumer-related companies and other sectors targeted by the government can make sense. This means targeting ETFs with heavy exposure to P-chips or N-shares (see our 2014 China ETF Guide for details).

Currently, the major China ETFs, such as the iShares China Large-Cap ETF (FXI | B-48), the iShares MSCI China ETF (MCHI | B-43) and the SPDR S&P China ETF (GXC | B-44), by design are heavily weighted in SOEs that dominate the financials, energy and telecom sectors.

For example, financials (mostly all SOEs) utterly dominate FXI, with a 55 percent weighting, as well as MCHI and GXC, with 37 and 31 percent, respectively.

Noteworthy China ETF Exposure

Luckily, there are several ETFs, albeit smaller than the older and much bigger ones, that offer greater exposure to some of China’s entrepreneurial and consumer-focused companies.

One of my favorites in this space has been the Global X China Consumer ETF (CHIQ | B-37). For 65 basis points, the $150 million CHIQ holds a concentrated portfolio of 40 investable “offshore” Chinese stocks from the consumer cyclicals and non-cyclicals sectors.

Liquidity in CHIQ isn’t exactly robust, trading $500,000 a day, at 19 basis-point spreads, but it’s more than enough for most retail folks. One sour spot is that CHIQ’s portfolio currently isn’t “cheap,” with a trailing price-earnings ratio (P/E) of 19.89.

The Guggenheim China Small Cap ETF (HAO | C-27) is another interesting play here, as its small-cap focus shuns the major SOEs. For 75 basis points, the $221 million HAO holds more than 260 investable “offshore” Chinese securities.

In HAO’s current composition, financials are significantly cut down to about 17 percent, while industrials make up roughly 19 percent, and consumer-focused firms make up more than 20 percent. HAO is the most liquid small-cap option, with more than $5 million traded daily, at 11 bps spreads.

Turning to the A-shares market, Van Eck recently brought us something new and innovative with its Market Vectors ChinaAMC SME-ChiNext ETF (CNXT). For 68 basis points, this new “RQFII ETF” selects 100 of the largest companies that list on Shenzhen’s SME and ChiNext boards.

As the name suggests, the SME and ChiNext boards cater to smaller companies, many of which are high-tech companies. China’s markets are obviously very different from the U.S., so it’s difficult making direct comparisons, but this index reminds me of the Nasdaq in the mid-1990s, when many tech startups were listing.

As expected, CNXT has a 23 percent weighting in IT, with another 26 percent in consumers and 10 percent in health care (financials are a measly 3.7 percent).

Innovation On The Horizon

Looking out on the horizon, there are a number of sector-specific RQFII ETFs on my radar, including a pair of consumer funds and a health care fund from Deutsche X-trackers.

I’m not the biggest fan of large-cap China ETFs, but I wouldn’t be surprised to see the Source CSOP FTSE China A50 ETF, currently in filing, launch with significant institutional backing, because it’ll track the most liquid A-share index in the world. I view this ETF as an “A-share” version of FXI.

Still, I think the true innovation will be seen in the fixed-income space. There’s now a slew of RQFII ETFs in the pipeline targeting China’s mainland fixed-income market, which offers plump yields.

I’m paying particularly close attention to three ETF issuers in the RQFII space: Deutsche X-trackers, Market Vectors and KraneShares.

In fact, they all have broad China bond ETFs in filing, and KraneShares even has a pair of China commercial paper ETFs in filing.

No Easy Choice

If China can pull off a soft landing as it works through its current debt woes, and sentiment does become positive, innovative issuers who are first to market are likely to reap big rewards.

For now, China remains a tale of two markets—onshore and offshore, and China’s state-capitalist structure and complicated equity markets don’t fit the mold of many index methodologies.

While the Deutsche X-trackers Harvest MSCI All China Equity ETF (CN) finally offers an “all China” approach around share classes, China’s grand plans to orchestrate a major shift in its growth model from exports to consumption also makes it difficult to capture these themes in one ETF wrapper.

Therefore, serious China investors just might have to continue tapping multiple ETFs for the foreseeable future.

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