Limiting Premiums On China A-Share ETFs

In September, I blogged about the possibility of the Deutsche X-trackers Harvest CSI 300 China A-Shares ETF (ASHR | D-50) surging above its net asset value due to creation limits imposed on the fund because assets were nearing its renminbi qualified foreign institutional investor (RQFII) quota.

In the past three months, China’s mainland benchmark CSI 300 Index, which the $738 million ASHR tracks, has soared by almost a third, causing a few bouts with premiums and forcing the fund to secure more quota.

Since Sept. 11, ASHR has limited creations to one unit a day; increased creation limits back to 10 a day; decreased it again to one per day; then increased it back to five, where the limit currently stands. In addition, the fund has been able to increase its quota from 3.63 billion RMB in September to $4.32 billion.

On Tuesday of this week, the CSI 300 finally had a massive pullback of 4.5 percent, allowing the market price of ASHR shares to fall back toward its net asset value (NAV). Still, that doesn’t change ASHR’s challenges overnight.

Moreover, folks who bought shares on Monday got hurt from not only a plunging NAV, but also from a collapse in the fund’s share price premium.

The takeaway here is that until China’s State Administration of Foreign Exchange starts granting more RQFII quotas in Hong Kong, ASHR could face periodic bouts of premiums if demand stays strong, so prudent monitoring of the fund’s price relative to NAV is necessary, especially for new investors.

ASHR’s Road To Premiums

This premiums chart shows when things went awry:

Source: Bloomberg

Don’t focus too much on the small deviations leading up to November. I view those as mostly “noise,” because the fund’s NAV is stale from Asia’s closing prices. ASHR often acts as a price discovery vehicle during New York hours, based on new market developments while underlying Asian markets are closed.

Instead, focus on November, when the CSI 300 started to go parabolic. You start to see a premium developing toward 5 percent. This was likely more structural, as the fund wasn’t able to create shares fast enough to keep up with demand.

Notice that in November—at least up until Nov. 24, when creations again were decreased back to one unit a day—flows are constant at around $13 million a day. That’s in line with the 10-creation-unit limit at the time. (I arrived at the $13 million-per-day figure by multiplying the fund’s NAV of $26 NAV by 50,000 shares, which equals $1.3 million per creation unit. In turn, 10 creation units of that equals about $13 million.)

On Dec. 1, the premium collapsed when creations were increased to five units a day. ASHR spiked again to a premium of about 7 percent in the following days, only to collapse again after Tuesday’s huge sell-off.

What Can Investors Do?

For long-term investors already holding ASHR, one option is to simply do nothing. I still expect these quota issues to be temporary, and over the long haul, this too could simply pass as noise.

Of course, there’s no way to know exactly when a flood of quotas will be granted to Hong Kong RQFII firms, but it’s hard to imagine the Chinese government shooing away global investors. They’re trying to open China’s mainland markets, not the other way around.

For shareholders wanting to capitalize on this scenario—and, to be clear, I’m not advocating doing this—an option would be to sell ASHR if it spikes again to a big premium, thereby banking the premium, and then buying the Market Vectors ChinaAMC A-Share ETF (PEK | D-49), which tracks the same index as ASHR.

PEK currently has $75 million in assets and doesn’t have any creation limitations. Of course, PEK could ultimately face the same challenges as ASHR if it gets too big.

Finally, for new investors looking to buy shares in ASHR, being careful about the price you’re paying relative to NAV could save you heartache. It’s hard to stomach seeing a recently purchased fund at a premium collapse back to NAV only a few days later.

Takeaway

I want to point out that in light of the overwhelming demand in the face of quota limitations (which DBX cannot control), the issuer has done a great job managing these challenges. DBX has adjusted by limiting creations and somehow securing incremental quotas here and there.

Even if ASHR hits its quota, the fund likely won’t halt creations altogether either. Instead, it can continue creating shares using FTSE A50 futures traded in Singapore. That would not be ideal from a tracking perspective, but it can work as a temporary stopgap.

ASHR hasn’t halted creations, but it faces challenges. We consider its daily five-creation-unit limitation an “impediment” to its creation process, which can still cause premiums.

So, in the meantime, new investors should keep an eye out for any excessive premiums before purchasing shares.

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