Why It's Crucial To Rethink China ETFs

Investors need to know that, for now, not all China-focused equity investments are created equal.

Investors need to know that, for now, not all China-focused equity investments are created equal.

[Editor’s Note: This is the first of a two-part blog discussing the need to rethink “China investing” as the country transitions from an export- to consumption-led growth model and issuers launch innovative new ETFs. Part I will discuss the fragmented Chinese equity market, while Part II will discuss attractive alternatives to broad, cap-weighted ETFs for China 2.0 investing.]

China’s economy is at a crossroad, leaving investors confused about its future. Some predict a real estate debacle and a hard landing, while others predict a soft landing and see value in Chinese shares.

Goldman Sachs, Morgan Stanley and Citigroup see Chinese equities rebounding in the second half of 2014, but they’re mostly talking about Hong Kong-listed Chinese shares. What about mainland-listed shares?

With issuers launching innovative new ETFs and China’s fragmented equity markets producing significantly differing returns, it’s time to rethink China ETFs.

China’s multishare class equity structure looks complicated and intimidating on the surface, but it doesn’t have to be. For a fine overview, check out our China ETF Guide for a deep dive.

A simplified way to look at Chinese equities is to separate them into two distinct markets: “onshore” and “offshore.”

The onshore—or mainland—market consists of Shanghai- and Shenzhen-listed shares that are still largely off limits to global investors, except through quota programs like QFII and RQFII. (Those are the acronyms for the “qualified foreign institutional investor” program and the “qualified foreign institutional investor” program.)

Meanwhile, the offshore market consists of “investable” shares traded in Hong Kong and the U.S.

China is truly the tale of two markets, as they have historically shown different returns and correlations with each other.

Onshore Vs. Offshore: Returns And Correlations

Here we have the S&P China BMI Index—tracked by the SPDR S&P China ETF (GXC | B-41)—to represent the offshore market. We’ll use the CSI 300 Index—tracked by the db X-trackers Harvest CSI 300 China A-Shares ETF (ASHR | D-51)—to represent the onshore market, and the MSCI All China Index—tracked by the newly launched db X-trackers Harvest MSCI All China Equity ETF (CN)—to represent “total” China.

Source: Bloomberg

In just the past year, the difference in returns between onshore and offshore China is staggering. Even though both the S&P and CSI indexes are “broad” benchmarks, the offshore market outperformed the onshore market by more than 25 percent!

1-Year Daily Correlations (7/4/2013 - 7/4/2014)

Source: Bloomberg

There are several reasons for the disparity in returns and low correlations between the onshore and offshore market.

The onshore market is still largely closed to foreigners, meaning it has a separate liquidity pool from global markets. Besides accessibility issues, many mainland-listed companies don’t list their shares overseas, and vice versa, so you’re looking at a different basket of companies as well.

The Offshore Market Twist

While breaking down China into the onshore and onshore market is the first step, there’s a twist within offshore ETFs that’s critical to understand. After all, 22 of the 28 China-focused ETFs listed in the U.S. target the offshore market.

Let’s look at the three largest and most popular “broad” China offshore ETFs: the iShares MSCI China ETF (MCHI | B-41), the PowerShares Golden Dragon China ETF (PGJ | A-22) and SPDR’s GXC.

Here’s a chart of their returns over the past year (July 3, 2013 - July 3, 2014):

Charts courtesy of StockCharts.com

The simple explanation for this massive disparity in returns is that MCHI only holds Hong Kong-listed shares, whereas PGJ holds only U.S.-listed shares. Meanwhile, GXC holds both Hong Hong- and U.S.-listed shares.

Over the past year, China’s hottest sector was “technology.” I put technology in quotations because China’s tech space is still nascent, and the sector is dominated by Internet companies, practically all of which list their shares solely in the U.S.

The CSI Overseas China Internet Index is up close to 70 percent in just the past year! These Internet companies also happen to reach into the consumer sector due to the massive growth in China’s e-commerce market.

So, if you look at the three funds’ sector exposures, it’s clear that the funds with the largest “tech” exposure were outperformers:

Source: ETF.com

I’m still baffled as to why MCHI continues to be the most popular broad China ETF, with $940 million in assets. I still hear financial advisors pitching MCHI for the broadest China exposure, and it leaves me scratching my head wondering why.

MCHI doesn’t even provide the broadest exposure to the offshore market. Specifically, it excludes all Chinese Internet companies (with the exception of Hong Kong-listed Tencent), which are some of the fastest-growing, entrepreneurial companies in China.

I’m sure you’ve heard of some of these names: Baidu, SINA, Weibo, JD.com, NetEase, Qihoo 360 Technology, Youku Tudou, Sohu.com, Ctrip.com—the list goes on and on.

Let’s also not forget about Internet behemoth Alibaba, which is planning an initial public offering in the U.S. in the coming months. Barring some kind of methodology change at MSCI, it’s highly unlikely Alibaba will be included in MCHI.

(MSCI assigns securities to a country based on incorporation and primary listing, and since many N-shares solely list in the U.S., they aren’t eligible for inclusion in the fund’s underlying index.)

I’m personally a big fan of MSCI. Its strict rules-based methodology makes it the trusted indexing giant it is. But when it comes to China, I prefer to look outside of MCSI’s global index series.

To put things into perspective in a way that will make perfect sense to U.S. investors, if you’re searching for the broadest coverage of the U.S. equity market, would you ever buy an ETF that excludes Google, Amazon, Yahoo, Twitter, Facebook, eBay and so on? You get my point.

Meanwhile, PGJ only holds U.S.-listed shares, so, naturally, it’s highly concentrated in Internet companies—which, as I said, explains most of its massive outperformance over the past year.

Despite its stellar performance, I’m not the biggest fan of PGJ. It doesn’t even target a specific sector or theme.

In a nutshell, PGJ is a hodgepodge of Chinese companies from sectors restricted from foreign direct investment—the Internet being one of them—that list their shares in the U.S. through a variable interest entity structure. PGJ is also mixed together with American depositary receipts of Chinese companies listed in Hong Kong.

What happens to PGJ if high-flying Internet shares take a beating after Alibaba’s IPO?

I’m not saying that playing the current momentum in China’s Internet space isn’t a legitimate tactical strategy. But if you want China Internet exposure, why wouldn’t you just go with a pure-play like the KraneShares CSI China Internet ETF (KWEB | C-23)?

If you’re looking for the most comprehensive exposure to China’s offshore market, GXC is the clear winner here, as it includes everything MCHI has, plus all the U.S.-listed tech companies.

What about costs? GXC has a median rolling 12-month tracking difference of -113 basis points versus MCHI’s -57 basis points. So, GXC has higher overall holding costs. But I think that’s a small price to pay compared with the additional exposure you get to some of China’s fastest-growing companies.

The Path To Total China

Luckily, investors now have an option to capture both the onshore and offshore market in one ETF wrapper with Deutsche Bank’s newly launched CN.

The fund holds all investable shares, plus the exchange-traded funds ASHR and the db X-trackers Harvest CSI 500 China A-Shares Small Cap (ASHS), for their exposure to the onshore market. I have concerns about using a CSI-indexed ETF to track an MSCI index, but CN remains the most comprehensive total China ETF at the moment.

The tale of two China markets will likely continue for several years, but I fully expect major disparities between them to lessen as China gradually opens its domestic market to global investors.

But the big question remains: Is going broad still the best way to invest in China’s next phase of growth?

China is embarking on a historical change from an export- and investment-driven model to a consumption-driven model, and being tactical in China is becoming attractive.

There are now numerous sector- and theme-specific China-focused ETFs. New RQFII ETFs targeting the onshore market are also being launched left and right.

I’ll discuss which ETFs look promising for China 2.0 in the second part of this blog, which will be published in the coming weeks.

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.