KBA, Best China A-Share ETF For Now

With the China A-share market now open, ETF investors have some choices to make.

U.S. ETF issuers finally have cracked the code to access the holy grail of investing in China—the physical A-shares market, and the question about which ETF to choose is now relevant.

Because now, working with renminbi qualified foreign institutional investors subadvisors in Hong Kong, U.S. issuers can operate ETFs that hold actual physical A-shares of companies listed on either the Shanghai or Shenzhen stock exchanges.

So far there are three such A-share funds. They are:

• db X-trackers Harvest CSI 300 China A-Shares ETF (ASHR), the largest of them, has garnered about $160M in AUM since its November 2013 launch.
• Market Vectors China AMC A-Share ETF (PEK | F-47) lags far behind in assets, with $32 million, even though it arrived first. (The caveat is that when it launched, it achieved its A-share exposure using derivatives, but only changed to actual A-shares after Deutsche Bank’s launch of ASHR.)
• Finally, KraneShares has just launched the KraneShares Bosera MSCI China A Shares ETF (KBA).

While KraneShares’ KBA is a bit late to the party, I think KBA is a better product than either ASHR or PEK. I base that on an examination of the funds’ respective index construction methodologies.

Below is a snapshot of index constituent information.

Figure 1: Index Constituent Comparison as of 2/28/2014

Unlike the CSI 300 Index, around which ASHR and PEK are built—which has a fixed number of index constituents—the MSCI China A Index underlying KraneShares’ KBA aims to cover 85 percent of the A-shares market by capitalization.

The significance of that is that the index reaches further down the market-capitalization spectrum, and the index will evolve with the market.

But exactly why is it better?

With Reforms, It’s No Longer Business As Usual

Economic and financial reforms announced in the Third Plenary Session 2013 should benefit companies further down the capitalization echelon at the expense of traditional mega-caps that are the focus of the iShares China Large-Cap ETF (FXI | B-51).

Currently, the CSI 300 Index is dominated by state-owned enterprises (SOEs), which amount to 69 percent of the portfolio. The CSI 300 Index also has a very heavy exposure to the financial sector, with 37 percent by weight.

As the regime pushes for market-oriented reforms, I expect a margin and profit squeeze on inefficient banks that have been relying on various government subsidies.

Additionally, many of the industrial and manufacturing giants that did so well in China over the past 30 years will have to reinvent themselves to remain competitive, as overcapacity and low labor and capital efficiency loom large.

I expect significant industry and market consolidation once real market reforms have been put in place.

The advantages smaller firms down the capitalization spectrum have are that they’re more flexible in dealing with reforms and adjusting to the new competitive dynamic.

They are also less dependent on government subsidies. I expect smaller firms with good business models and solid financials to outperform traditional mega-cap giants.

CSI 300 Millstone

Picking only the most liquid and the largest 300 companies by market cap, the CSI 300 will likely miss the strong performance coming from smaller companies. The chart below clearly illustrates that smaller companies have outperformed larger companies.

According to the chart below, performance is inversely related to capitalization. The CSI 200 Index is a midcap index, while CSI 500 Index is a small-cap index.

While I’m not ready to call it a rule of thumb, I believe that smaller firms, as they did in 2013, are likely to continue to outperform large-caps moving forward.

While MSCI China A Index’s 85 percent approach aims to cover large- and midcaps, it also covers quite a few small-caps currently in the CSI 500 Index. In other words, I believe the inclusion of “small-caps” will likely help with KBA’s performance over ASHR in the near future.

In this vein, it’s worth noting that Deutsche Bank has a CSI 500 Index ETF in registration. It’ll be interesting to see if the small-caps can repeat their strong 2013 performance in 2014.

The CSI 300 Is Not Enough

As China’s economy and equity market evolve and grow, so will the MSCI China A Index.

After all, the China Securities Regulatory Commission indicated plans to restart the IPO pipeline for the domestic market.

The problem with the CSI 300 Index is that because it only has 300 stocks, it will certainly miss out on most of the growth and evolution of the Chinese equity market.

The index, which may at one time have been a solid representation of the A-shares market, will lose those qualities as the China A-share market grows and evolves and becomes something of a legacy view of the past.

But the MSCI China A Index will evolve with the market; adding more companies and maintaining the capitalization representation at about 85 percent will ensure exposure to the midcap space and some small-cap firms. To be sure, you can argue an evolving 85 percent might not be a complete representation of the A-shares market, but it sure is better than a hard-and-fast 300.

The bottom line is this: If you want broad-market exposure to the China A-share market but are also wary of small-cap volatility, I believe that KraneShares’ KBA is the best China A-share index ETF available on the market to-date. It offers the best neutral representation of the large- and midcap China A-share market.

Afterthought: While KBA may be the best China A-shares ETF currently available, it’s not perfect.

I’m looking forward to the day when a comprehensive China ETF exists that includes all share classes—not just A-shares—using noncapitalization indexing methodologies, such as fundamental weighting. That would help steer U.S. investors toward those Chinese firms that are dynamic and truly competitive, instead of firms born out of some legacy corporate welfare program sponsored by the central government in the world’s second-largest economy.

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