A more recent White Paper is available: Definitive China ETF Guide 2015
2014 Update: China ETFs saw tremendous innovation over the past year with the introduction of renminbi qualified foreign institutional investor (RQFII) ETFs. Our guide has been fully updated to incorporate the rise of RQFII ETFs, what that means for broad emerging markets indexes, and what to expect in the coming years from issuers attempting to capitalize on this new frontier.
Table of Contents
- Introduction
- Share-Class Descriptions
- ETF Share-Class Breakdown
- N-Shares and the Variable Interest Entity Structure
- Rise of the RQFII ETFs
- Broad Emerging Market ETFs
- On the Horizon: 2014 and Beyond
- Conclusion
Investing in China just got even trickier. There are now more than 30 U.S.-listed China equity ETFs to choose from, ranging from size and style funds to sector- and theme-specific funds.
As if sifting through expense ratios, liquidity and holdings isn't enough, China investors also have a big, fundamental factor to consider: Chinese share classes.
As a result of foreign investment still being largely restricted in China, there are multiple shares classes of Chinese companies floating around on various exchanges, allowing investors different ways to access this complex market.
Some ETFs are eligible to hold only a certain type of shares, which impacts the types of Chinese companies held in the fund's portfolio, ultimately impacting the ETF's performance. Chinese share classes, especially as they relate to ETFs, are often misunderstood—or worse, ignored altogether.
We at ETF.com think investors deserve better, so we prepared this document to provide insight and guidance on the topic to help investors make an informed decision on choosing the right China ETF.
Except for a select few qualified foreign institutional investors (QFIIs) and renminbi qualified foreign institutional investors (RQFIIs), (see "Rise of the RQFII ETFs") most investors cannot readily buy "A-shares."
Due to this restriction, most U.S.-listed ETFs currently hold shares of Chinese companies listed in Hong Kong, the U.S. or a special "B" share class traded in Shanghai or Shenzhen. These "investable" shares consist of H-shares, red chips, P-chips, N-shares and B-shares.
Let's look at each of these shares below, because grasping their differences is crucial.
- A-shares: Chinese companies incorporated on the mainland and traded in Shanghai or Shenzhen, quoted in RMB.
- H-shares: Chinese companies incorporated on the mainland and traded in Hong Kong.
- Red chips: State-owned Chinese companies incorporated outside the mainland (mostly in Hong Kong) and traded in Hong Kong.
- P-chips: Nonstate-owned Chinese companies incorporated outside the mainland, most often in certain foreign jurisdictions (Cayman Islands, Bermuda, etc.) and traded in Hong Kong.
- N-shares: Chinese companies incorporated outside the mainland, most often in certain foreign jurisdictions, and U.S.-listed on the NYSE or Nasdaq (American depositary receipts (ADRs) of H-shares and red chips are also sometimes referred to as N-shares).
- B-shares: Chinese companies incorporated on the mainland and traded in Shanghai and quoted in USD or traded in Shenzhen and quoted in HKD (open to foreign ownership).
It may come as a surprise that some of the most popular China ETFs are not eligible to hold all "investable" shares.
For example, the $5 billion iShares China Large-Cap ETF (FXI | B-52), which tracks the FTSE China 25 Index and holds 25 of the largest and most liquid Hong Kong-listed Chinese shares, is only eligible to hold H-shares, red chips and P-chips.
This means Baidu, one of China's largest Internet companies, which has a market capitalization over $55 billion, is excluded because it's solely listed in New York (N-Share).
The key to understanding share class eligibility lies in knowing the fund's underlying index. FTSE and MSCI, both leading index providers in the space, assign securities to a country based on incorporation and primary listing.
Since many N-shares are incorporated in tax havens like the Cayman Islands or Bermuda, and have their primary listings in the U.S. (see "N-Shares and the Variable Interest Entity Structure"), they aren't eligible in their standard China indexes.
Therefore, China ETFs that track FTSE and MSCI indexes are limited in scope, as the indexers' classification methodology determines where that company sits in their country breakdown (MSCI's "All China" index series is the exception).
Practically all Chinese Internet companies—with the exception of Hong Kong-listed Tencent Holdings—list in New York. This means popular funds like the iShares MSCI China ETF (MCHI | B-42) also exclude many significant N-shares beyond Baidu, such as SINA, Ctrip.com, Qihoo 360 Technology, NetEase and Youku Tudou.
This has some profound implications for funds like MCHI and FXI regarding the Alibaba IPO. The upcoming IPO of the Chinese Internet behemoth, which recently chose New York to list its shares, will likely be ineligible for inclusion.
Furthermore, SINA recently spun off micro-blogging site Weibo, "China's Twitter," in a U.S.-listed IPO. Several other Chinese Internet companies are slated to list in the U.S. in the near future that MCHI and FXI will likely be ineligible to hold as well.
(Note: MSCI's scope is slightly wider than FTSE's because MSCI indexes also hold B-shares. Still, B-shares are practically defunct, and carry little to no weighting in funds).
Investors looking to get a broad mix of all investable Chinese shares have better options, such as the SPDR S&P China ETF (GXC | B-40). GXC holds all investable shares, providing the most comprehensive "offshore" exposure to the Chinese market currently available to U.S. investors.
For comprehensive coverage, Deutsche Asset & Wealth Management recently broke new ground with its db X-trackers Harvest MSCI All China ETF (CN). The fund is the first of its kind, offering “onshore” and “offshore” exposure in one ETF wrapper.
CN tracks the MSCI All China Index, an index series from MSCI that includes all share classes, regardless of where they’re listed. CN is a partial “fund of funds,” holding Deutsche’s own RQFII ETF, the db X-trackers Harvest CSI 300 China A-shares ETF (ASHR) for its A-shares component of the fund.
N-Shares and the Variable Interest Entity Structure
The PowerShares Golden Dragon China ETF (PGJ | A-23) is an interesting case because it's only eligible to hold U.S.-listed Chinese shares, or N-shares.
PGJ's holdings consist of a mixture of ADRs of H-shares and red chips that trade in Hong Kong, and N-shares of companies that have their primary listing in the U.S., and use a variable interest entity structure (VIE).
This VIE structure is worth discussing in greater depth, as there's been quite a bit of scrutiny in recent years surrounding the regulation and legality of VIEs.
Certain sectors in China are restricted from foreign direct investment. Therefore, companies operating in restricted sectors like Internet, media and education set up holding companies overseas, usually in tax havens like the Cayman Islands or Bermuda, and float shares of the holding company in overseas markets (such as the NYSE or Nasdaq).
Investors have ownership in a wholly foreign-owned entity (WFOE) in China, which enters into contractual agreements with the VIEs to share in the profits. The VIEs, which maintain the business licenses, are often owned by a select few executives—sometimes just the founder.
The Chinese government has not addressed the legality of this structure, and so far, has simply turned a blind eye to it. Furthermore, the details surrounding the control of the operating companies and regulation of the VIE structure are questionable.1,2,3
SINA Corp was the first company to list in the U.S. using this structure, in 2000. Over the next decade, hundreds of other Chinese companies listed using VIEs, and continue to do so today.
Speculation about whether the Chinese government (and/or the SEC) will crack down on this structure and tighten regulation on VIEs continues to this day. While no formal announcements have been made, the possibility of regulations around the VIE structure is always on the table.
RQFII ETFs are a new breed of China ETFs in the U.S. and can be considered the second generation of A-share funds. RQFII ETFs directly hold A-shares, as opposed to using derivatives to access the restricted market, the way first-generation funds had to do.
First, a bit of background on the QFII and RQFII programs may be in order to understand how these new funds work.
The QFII program was started in 2002 to allow certain institutions to trade A-shares, up to a specific quota. The China Securities Regulatory Commission (CSRC) approves QFIIs, while the State Administration of Foreign Exchange (SAFE) grants quotas.
For each institution, the quota is currently $1 billion. For the entire QFII program, the total quota was recently raised in July 2013 from $80 billion to $150 billion. It's estimated that only about a third of the total $150 billion quota has been issued as of this writing.
Previously, first-generation A-share funds had to engage in swap-agreements with QFIIs, which wasn't an ideal structure for several reasons.
For starters, funds engaged in swaps carry counterparty risk. This means if the counterparty (QFIIs, in this case) fails as an entity, or fails to deliver on its end of the deal, shareholders could be affected.
Secondly, QFIIs themselves have quotas, so when demand is strong for A-shares, swaps get more expensive. This caused funds to trade at premiums to its NAV, sometimes north of 10 percent.
The RQFII program was implemented in December 2011, with an initial quota of 20 billion yuan ($3.2 billion). The program allowed Hong Kong subsidiaries of Chinese firms to raise offshore renminbi (in Hong Kong) to buy mainland securities.
Since then, the total quota has been expanded more than tenfold to 270 billion yuan ($43 billion), and the program was extended in March 2013 to allow international banks and asset managers with a Hong Kong presence to participate in the program.
In late 2013, Singapore and London officially joined Hong Kong to become offshore renminbi hubs, with initial RQFII quotas of 50 billion and 80 billion yuan, respectively.
So what does this all mean for U.S.-listed ETFs?
Issuers in the U.S. are teaming up with RQFII-licensed firms in Hong Kong and tapping them as the funds' subadvisors, enabling the ETFs to gain access to A-shares, up to a specific quota.
Deutsche Asset & Wealth Management was the first issuer to launch a U.S.-listed RQFII ETF, in November 2013, by partnering with Harvest Global Investments. The db X-trackers Harvest CSI 300 A-Shares ETF (ASHR) launched with a staggering $104 million in seed capital, suggesting strong institutional backing.
Until ASHR launched, A-share investors had two options: the Market Vectors ChinaAMC A-Share ETF (PEK | F-35), which formerly used swap agreements with QFIIs to track the CSI 300 Index; and the PowerShares China A-Share ETF (CHNA | F-48).
Soon after the launch of ASHR, however, Van Eck relaunched PEK as an RQFII ETF by teaming up with China Asset Management Co. In March 2014, KraneShares partnered with Bosera Asset Management and launched the third RQFII ETF, the KraneShares Bosera MSCI China A Share ETF (KBA).
CHNA continues to use futures contracts traded in Singapore to track the FTSE A50 Index. However, the actively managed fund reserves the right to hold various shares, and at some point may itself become an RQFII ETF.
Finally, worth mentioning are quota limitations. While these exciting new products provide direct access to the mainland market, they are still bound by quotas, which are granted by SAFE on a fund-by-fund basis.
Deutsche Bank's ASHR has an initial quota of 2 billion yuan ($320 million), while Van Eck's PEK and KraneShare's KBA both have initial quotas of 1 billion yuan ($160 million).
If a fund hits its quota, it will need to request a quota increase from SAFE. If the fund cannot obtain a quota increase in sufficient time, it may have to resort to derivative products or even halt creations in the interim. This in turn could lead to the ETF trading at premiums to its NAV.
Several regional or global ETFs with significant China exposure are subject to the same share-class restrictions, based on the indexes they track.
For example, the $43 billion Vanguard FTSE Emerging Markets ETF (VWO | C-90) tracks a FTSE index, and the $36 billion iShares MSCI Emerging Markets ETF (EEM | B-100) tracks an MSCI index, so N-shares are excluded from these funds.
Meanwhile, the SPDR S&P Emerging Markets ETF (GMM | D-88) tracks an S&P index, so it's inclusive of all investable shares.
We see a similar pattern when comparing BRIC-themed ETFs, which have even larger allocations to China.
The iShares MSCI BRIC ETF (BKF | C-97) has a 45 percent weighting in China. But again, since it tracks an MSCI index, investors won't find any N-shares here.
The Guggenheim BRIC ETF (EEB | C-53) is an extreme case, as it's only eligible to hold depositary receipts and N-shares. This means its 31 percent weighting in China excludes the "big four" Chinese state-owned banks because none of them floats ADRs.
Meanwhile, the SPDR S&P BRIC 40 ETF (BIK | B-67) is inclusive of all Chinese shares, and carries a massive 53 percent weighting in China. From a Chinese exposure perspective, BIK is the most comprehensive.
On the Horizon: 2014 and Beyond
In the past year, there's been tremendous innovation with China ETFs, especially around RQFII funds. We expect that trend to continue as China gradually opens up its markets to the rest of the world.
Here's a highlight of some major events that China ETF investors should monitor.
A-Share Incorporation into Broad EM Indexes
The most significant change to broad emerging market indexes in more than a decade is the upcoming inclusion of A-shares.
According to MSCI, large- and midcap A-shares now have a market cap of roughly $880 billion, which accounts for about 50 percent of China's $1.7 trillion market cap in MSCI's standard index series.
In the MSCI Emerging Markets Index, tracked by EEM, China—as represented by H-shares, Red Chips, P-chips and B-shares—makes up roughly 18 percent. In the FTSE Emerging Markets Index, tracked by VWO, China represents roughly 16 percent.
If A-shares were fully incorporated into MSCI's flagship EM index with no quota restrictions, it would account for almost 28 percent of the index (if South Korea, which carries a 16 percent weighting, is reclassified as a developed nation, China's weighting is likely to become even higher).
MSCI has only begun reviewing the inclusion of A-shares, and an announcement on the proposal is expected in June 2014. Furthermore, even if it's announced that A-shares will begin their inclusion into the index in May 2015, the transition will be gradual, taking effect over the course of several years.
Finally, worth mentioning is that even after incorporating A-shares begins, the MSCI EM Index and FTSE EM Index will still exclude N-shares. So, Alibaba's IPO is still unlikely to be included in these indexes.
On April 10, 2014, China announced it would begin permitting cross-exchange trading between Hong Kong and Shanghai, up to a specific daily quota. The pilot program is expected to begin in the fall of 2014.
Initially, the daily quota will be a combined 23.5 billion yuan ($3.8 billion), which is expected to be increased gradually over time. Investors in mainland China will have daily quota of 10.5 billion yuan, while H.K.-based investors will have a daily quota of 13 billion yuan.
This program is expected to impact shares of dual-listed companies. Historically, there have been premiums and discounts associated with A-shares and H-shares since they're based on different liquidity pools and the mainland market is restricted.
These premiums and discounts can be measured by the Hang Seng China AH Premium Index. An index value of 100 indicates parity. A value above 100 indicates A-share premiums, while a value below 100 indicates A-shares discounts.
The index was 94.05 as of April 21, 2014, suggesting a discount for A-shares. It's expected that the AH gap will diminish or close altogether once trading between the markets convenes, since there will be arbitrage opportunities that should bring dual-listed shares back to parity.
In September 2014, the FTSE China 25 Index, the most popular and liquid China index in the world, will go through a significant change. Effective Sept. 22, 2014, the index tracked by ETFs, like the $4 billion FXI, will officially become the FTSE China 50 Index.
According to FTSE, the new index will extend its holdings by 25 names over a three-month transition period to hold 50 of the largest and most liquid H.K.-listed Chinese companies. Post-transition, FXI's financial exposure will diminish by roughly 9 percent and will get a slight bump in consumer companies.
The launch of ASHR, PEK and KBA are only the tip of the iceberg. Many more RQFII ETFs are planned and expected to launch in the coming year (see table at the end of the paper).
Db X-trackers has a total of 8 RQFII ETFs in the pipeline. These include a small-cap ETF that will track the CSI 500 Index and seven sector-focused funds.
Van Eck also has a suite of RQFII ETFs lined up, including a small-cap fund, and a consumer- and dividend-focused ETF. Van Eck also has an "all China" ETF in the pipeline (Ticker: ALCH), based on the MSCI All China Index. It remains to be seen whether or not ALCH will use the RQFII scheme.
Source, an issuer with a large European presence, has the CSOP Source FTSE China A50 ETF in the works, slated for launch in June 2014. The fund will track the most liquid A-share index, the FTSE China A50 Index. Teamed up with CSOP Asset Management, Source has already launched this fund on the London Stock Exchange and the Deutsche Borse.
On April 16, 2014, BlackRock announced it was approved for RQFII status by the CSRC. While we haven't received any word on quota grants from SAFE, it's expected that iShares will use its parent company's RQFII status to launch its own A-shares specific funds.
While there are many different reasons beyond share classes for choosing the right China ETF, investors should understand that China investing comes with an extra layer of research.
Currently, complete coverage of the Chinese equity market can only be achieved with Deutsche Bank's CN, or by holding a comprehensive "offshore" ETF like GXC, together with an "onshore" ETF like ASHR or KBA. Soon, however, investors will have a few different options to be able to capture China's full market in a single ETF wrapper.
Exactly when all these new funds will launch, or when A-shares will be incorporated into broad emerging markets indexes, is still unknown. But slowly and gradually, China's markets are becoming accessible, and that is slated to continue.
We'll see a host of new innovation in the China ETF landscape in the coming years. We at ETF.com will continue to monitor any changes and new ETFs, so stay tuned.
In the meantime, the key to investing in China ETFs lies in knowing the differences between the various share classes. Once that hurdle is crossed and understood, choosing the right China ETF for your investment needs should become easier.
| RQFII Equity ETFs in the Pipeline | |||
| Fund Name | Ticker | Index | Share Classes |
| db X-trackers Harvest China Small Cap | ASHS | CSI 500 Index | A (RQFII) |
| db X-trackers Harvest China A-Shares Industrial | ASHI | CSI 800 Industrials Index | A (RQFII) |
| db X-trackers Harvest China A-Shares Technology | ASHK | CSI 800 Technology Index | A (RQFII) |
| db X-trackers Harvest China A-Shares Materials | ASHB | CSI 800 Materials Index | A (RQFII) |
| db X-trackers Harvest China A-Shares Health Care | ASHV | CSI 800 Health Care Index | A (RQFII) |
| db X-trackers Harvest China A-Shares Financial | ASHF | CSI 800 Financials Index | A (RQFII) |
| db X-trackers Harvest China A-Shares Consumer Staples | ASHP | CSI 800 Consumer Staples | A (RQFII) |
| db X-trackers Harvest China A-Shares Consumer Discretionary | ASHY | CSI 800 Consumer Discretionary | A (RQFII) |
| CSOP Source FTSE China A50 | TBD | FTSE China A50 Index | A (RQFII) |
| Market Vectors All China | ALCH | MSCI All China Index | A (RQFII) |
| Market Vectors China A Small-Cap | TBD | TBD | A (RQFII) |
| Market Vectors China A Consumer Demand | TBD | TBD | A (RQFII) |
| Market Vectors China A Quality | TBD | TBD | A (RQFII) |
| Market Vectors China A Quality Dividends | TBD | TBD | A (RQFII) |
| US-Listed China Equity ETFs | |||
| Fund Name | Ticker | Index | Share Classes |
| db X-trackers Harvest MSCI All China | CN | MSCI All China Index | A (ETF), H, B, Red Chips, P-chips, N |
| iShares FTSE China 25 | FXI | FTSE China 25 | H, Red Chips, P-chips |
| iShares FTSE China (Hong Kong Listed) | FCHI | FTSE (HK Listed) China | H, Red Chips, P-chips |
| WisdomTree China Dividend ex-Financials | CHXF | WisdomTree China Dividend ex Financials | H, Red Chips, P-chips |
| iShares MSCI China | MCHI | MSCI China | H, B, Red Chips, P-chips |
| iShares MSCI China Small Cap | ECNS | MSCI China Small Cap | H, B, Red Chips, P-chips |
| SPDR S&P China | GXC | S&P China BMI | H, B, Red Chips, P-chips, N |
| Guggenheim China All-Cap | YAO | AlphaShares China All-Cap | H, B, Red Chips, P-chips, N |
| First Trust China AlphaDEX | FCA | Defined China | H, B, Red Chips, P-chips, N |
| Guggenheim China Small Cap | HAO | AlphaShares China Small Cap | H, B, Red Chips, P-chips, N |
| Global X China Materials | CHIM | Solactive China Materials | H, B, Red Chips, P-chips, N |
| Global X China Consumer | CHIQ | Solactive China Consumer | H, B, Red Chips, P-chips, N |
| Global X China Energy | CHIE | Solactive China Energy | H, B, Red Chips, P-chips, N |
| Global X China Financials | CHIX | Solactive China Financials | H, B, Red Chips, P-chips, N |
| Global X China Industrials | CHII | Solactive China Industrials | H, B, Red Chips, P-chips, N |
| EGShares China Infrastructure | CHXX | INDXX China Infrastructure | H, B, Red Chips, P-chips, N |
| Guggenheim China Real Estate | TAO | AlphaShares China Real Estate | H, B, Red Chips, P-chips, N |
| Global X Nasdaq China Technology | QQQC | Nasdaq OMX China Technology | H, B, Red Chips, P-chips, N |
| Guggenheim China Technology | CQQQ | AlphaShares China Technology | H, B, Red Chips, P-chips, N |
| KraneShares CSI China Internet | KWEB | CSI Overseas China Internet Index | H, B, Red Chips, P-chips, N |
| KraneShares CSI China Five Year Plan | KFYP | CSI Overseas China Five-Year Plan | H, B, Red Chips, P-chips, N |
| Market Vectors China | PEK | CSI 300 | A (RQFII) |
| db X-trackers Harvest CSI 300 China A-Shares | ASHR | CSI 300 | A (RQFII) |
| KraneShares Bosera MSCI China A-Share | KBA | MSCI China A | A (RQFII) |
| PowerShares China A-Share | CHNA | N/A (Active) | A (Futures) |
| RBS China Trendpilot ETN | TCHI | RBS China Trendpilot | N |
| PowerShares Golden Dragon China | PGJ | Nasdaq Golden Dragon China | N |
| Direxion Daily FTSE China Bull 3X | YINN | FTSE China 25 | H, Red Chips, P-chips |
| ProShares Ultra FTSE China 25 | XPP | FTSE China 25 | H, Red Chips, P-chips |
| Direxion Daily FTSE China Bear 3X | YANG | FTSE China 25 | H, Red Chips, P-chips |
| ProShares Short FTSE China 25 | YXI | FTSE China 25 | H, Red Chips, P-chips |
Endnotes
- Gillis, Paul L., "Variable Interest Entities in China," Accounting Matters (Sept. 18, 2012).
- Dutton, Edward Drew and Wu, Niping, "Investing in China: New Risks?" Debevoise & Plimpton Private Equity Report, vol. 11, No. 4 (Summer 2011), pp. 3-5.
- Roberts, David and Hall, Thomas, "VIE Structures in China: What You Need to Know," Topics in Chinese Law, an O'Melveny & Myers LLP Research Report (October 2011), pp 1-3.
At the time this article was written, the author held long positions in ASHR and CHIQ. Contact Dennis Hudachek at [email protected], or follow him on Twitter @Dennis_Hudachek.
