Why Vanguard’s Frenzy For China A-Shares?

FTSE added China A-shares to its core benchmarks last week. This week, Vanguard announced it’ll be playing ball, and will add China A-shares to its flagship emerging market fund, the Vanguard FTSE Emerging Markets Index ETF (VWO | C-86). So it’s quite reasonable for investors to ask two important questions:

1. Why?
2. Should I care?

An A-Share Refresher

First, what the heck are A-shares anyway? A-shares are the local securities of Chinese companies trading on the Shanghai and Shenzhen exchanges. This puts them in contrast to so called “H” shares, which are the shares of Chinese companies listed in Hong Kong, and the “N” shares, which are the shares of Chinese companies listed in the United States.

Each one of these share classes has some unique properties, and ETF.com has a whole Definitive China ETF Guide 2015 on them. But, broadly speaking:

• N-shares tend to be tech companies. They come to the U.S. to get access to tech-hungry investors. Think Baidu and Sina and most recently, Alibaba.
• H-shares are decent mix of financial, tech and energy companies, with a smattering of other sectors.
• A-Shares come with quotas for foreign investors, so they’re not quite freely available. They tend to be loaded with financials and industrials.

Until recently, Chinese A-shares—considered by some investors to be the “real” Chinese companies—were not available to U.S. investors in any meaningful way. That changed in the fall of 2013, when Deutsche received a big chunk of quota from the Chinese government and decided to use it to launch the first A-share ETF, the Deutsche X-trackers Harvest CSI 300 A-Shares ETF (ASHR | D-56).

What’s The Buzz?

To answer my first hypothetical question: The reason investors are clamoring for A-shares is the same reason investors clamor for almost anything—they think A-shares are going to outperform. And guess what? They have indeed outperformed the Hong Kong version of China pretty handily over the last decade:

Between the run-up leading into the financial crisis and the recent rocket-ship performance, a 10-year-old investment in A-shares would have nearly doubled the performance of the already-red-hot Chinese market.

No Free Lunch

But in the immortal words of Robert Heinlein, “There ain’t no such thing as a free lunch.” In this case, the cost of your magic-performance bullet is risk. Here’s a quick study I ran out of FactSet’s Style Performance and Risk Analysis system. Each bubble here is the return and standard deviation of the relevant index for a 12-month period, rolling back over the last few years:

To me, the data are pretty clear. While the A-share index has had some periods of crazy performance, it has done so with nearly double the risk of boring old H-shares. Whether it’s worth taking those outsize risks to get those outsize rewards is certainly a matter of opinion, and you could data-mine the returns series to come up with fantastic Sharpe ratios—or terrible ones—depending on your time period.

The point is simply this: A-shares have historically been hugely more volatile, and hugely more profitable when they’re going up.

Should You Care?

As a first principle, I generally think that if you’re going to invest in a market, your default position should be broad exposure. So, if you want the “real” China, you want A-shares and H-shares and N-shares, and you also want all the small-cap stocks to boot.

That’s the move that Vanguard is making by adding A-shares and small-caps to its exposure inside VWO, so in general, I applaud it. But you should know that at least in some small way, the nature of your investment has changed—it’s gotten a little more interesting, but a little bit riskier.

More Froth Coming

It’s worth nothing that MSCI is due to opine about whether to roll A-share exposure into its headline China and emerging market indexes just next week. Should it make the move, it will only add more fuel to the A-share fire, and potentially add significant buying pressure onto the handful of large, investable companies in the A-share market.

And it’s especially worth nothing that all this movement by index providers isn’t changing the quota system. MSCI and Vanguard and BlackRock and my mom could all decide that A-shares are the place to be, and they could all run out of quota and find themselves unable to track their newly minted A-share friendly indexes.

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 Nadig at [email protected], or on Twitter @DaveNadig.