The Real China Problem: Market Structure

Until the recent downturn, China's stock market had been on fire. Flows into China-based ETFs in 2014 were $607 million, with an additional $2 billion in the first six months of 2015.

A lot of the attention had turned to so-called "A-shares"—the actual on-the-ground stocks trading on the Shanghai, Shenzen and related electronic exchanges. Until quite recently, A-shares were only available to mainland Chinese investors. All that changed when Deutsche Bank launched the Deutsche X-Trackers Harvest CSI 300 China A-Shares ETF (ASHR | C-60) back in November 2013.

Investors loved ASHR, and it now holds more than $791 million of investor cash—a notable feat for a very-niche product. And the competition has been fierce throughout China ETFs, a segment with nearly $15 billion in it right now.

Beaten-Down Market Breaks

Of course, the worm has turned. With the rapid decline of the Chinese markets (in all share classes), the Chinese regulators have enacted extraordinary measures to try and prop up falling prices. If you're investing in China, this might not be news, but I think it's important to understand the nearly inconceivable interventions that have happened in just a few weeks, and how they've fundamentally broken the way the market is supposed to work.

To summarize:

• Countless stocks have ceased trading. Many are scheduled to resume trading at the end of the month, but obviously there are no guarantees. Many of the top holdings in popular small-cap ETFs, like the Deutsche X-Trackers Harvest CSI 500 ETF (ASHS | D-73), haven't traded in weeks at this point, meaning any transactions you make, and any NAVs published, will be based on "best guesses" by both the market and the fund accountants with the unfortunate job of having to come up with a price for a closed security.
• Institutions holding more than 5 percent stakes in Chinese companies have been locked out of selling. While this doesn't affect any ETFs I could find (even the heavily indexed Hong Kong stocks have less than a few percent held by the major indexers), it fundamentally breaks the supply and demand relationship for shares, artificially inflating prices.
• The Chinese government is now actively supporting buying stocks on margin, making funding available expressly for this purpose. Honestly, I find this a terrifying proposition. Does anyone believe the "fair" price of a Chinese timber company will be sussed out by someone who was just given a gambling stake?
• Chinese retirement funds can now invest up to 30 percent of their assets in stocks. On the surface, this sounds like pretty rational Western-style investing, but it also will likely result in a short-term buying spree that doesn't actually aid in price discovery.
• Just today, regulators have said that banks can loan money to companies using company stock as collateral. To my mind, this actually puts the entire mainland banking sector at risk, and is precisely the kind of degraded capital structure Western regulators have been railing against for decades.

My Point (And I Do Have One) … 

It was just a few weeks ago that the press was singing the praises of the FTSE/Vanguard decision to get China A-shares into their emerging market indexes and products. At the time, I wrote that I understood the reasoning, but there were real risks involvedm risks that some have had to learn the hard way, however.

Strong YTD performance at the end of the first half has reversed into heavy losses as investors have moved serious cash out of these funds. 

Emerging markets are classified as "emerging" for good reasons. One of the largest factors (especially in the MSCI methodology) is "market accessibility"; specifically, the efficiency of the capital structure and the ease of access for foreign investors.

Until countries can ring the bell on having well-ordered and predictable markets, they stay relegated to emerging markets, precisely as a way to signal to investors that they've entered a part of the map where "here be dragons."

Market Structure Risk 

Governments and regulators can (and do) make mistakes. They over-intervene. They over-correct. Emerging market investors often think of political risk as their major boogeyman; say, like what's happening in Greece right now.

But the threat for investors in the Chinese markets goes beyond the political, and much more deeply into the actual structure of those markets. These unprecedented moves by Chinese regulators expose just how "emerging" the market there really is, and U.S. investors should be extremely skeptical about wading in.

One of the great joys of ETFs is the ease with which they let you access narrow and exotic corners of the world.

The most likely course of the Chinese intervention is that it slowly unwinds, and the markets return, eventually, to some sort of normalcy. But that outcome is by no means certain, and when the dust settles, who knows how many investors will have been spooked out of China for good?

Dave Nadig is the director of ETFs at FactSet Research Systems. At the time of this writing, the author held no positions in the securities mentioned. You can reach Dave at [email protected], or on Twitter @DaveNadig.