Is China’s Tech Crackdown Slowing?

October 19, 2021

Brendan AhernThe Chinese government launched a series of crackdowns on several sectors in the summer, from sweeping security reviews of tech companies listed on foreign exchanges, to requiring after-school tutoring companies to go nonprofit, to limiting how much video-game time children are allowed during the week.

That’s led to several big names questioning whether China’s political risk outweighs its value, but KraneShares Chief Investment Officer Brendan Ahern believes the most onerous regulatory additions are over.

This interview has been edited for clarity and brevity.

ETF.com: KWEB has a little over $6 billion in inflows this year, but the fund is down about 35% on returns. What do you think is happening there with such a difference on this fund?

Brendan Ahern: A combination of factors are at play. A lot of investors have potentially taken losses in the individual securities or found picking the winners across the KWEB companies very difficult, and are using KWEB to potentially take a loss or maintain exposure to the sector.

We've been speaking to a lot of investors institutionally for years, and they know our story, but the current fall in underlying securities makes an entry point into KWEB very advantageous today. We're seeing a number of institutional investors take positions in KWEB. That's true for financial intermediaries, RIAs, when the price action doesn't agree.

But we do believe when you look in, you’ll see the fundamentals of these underlying companies are very strong. Certainly, a diversified basket across this sector is a great way to initiate a position to this space without having to pick an individual winner.

ETF.com: There are quite a few big names in the investment world that have said in the past that China has become uninvestable, or they’re very worried about the political risk in that country. What do you think that people who are bears on China are missing in terms of its future prospects?

Ahern: There's a significant home bias to U.S. equities in the United States, that "the more you've diversified out of the U.S., arguably the worse you have done" is a common narrative. And that's driven by the reality that since the global financial crisis lull, the S&P 500 is up 730%, MSCI emerging markets is up 266% and MSCI China is up 254%.

But what investors often miss in looking at broad emerging markets or a broad China exposure is that those benchmarks were heavily skewed to value sectors like financials, energy, industrials and materials. They had very little exposure to growth sectors. And we would all agree that here in the U.S. that it's well-recognized that technology growth stocks have dominated the U.S. equity markets. That's a global phenomenon.

If we looked at a growth sector since March 2009, MSCI emerging markets technology is up 995% and MSCI China technology is up 3,230%. So if you've been allocated to the growth segment within emerging markets and China, you've actually had outsized returns.

The issue is you can't go out and buy emerging market technology because they change the definition of technology. (The index developers) put a lot of technology stocks into consumer discretionary. In the U.S., that's true for Amazon. For China and emerging markets, Alibaba went from being a tech stock to a consumer discretionary. Similarly, Facebook went from being a tech stock to the new communications sector. And that's true for Tencent as well.

This idea that China's become uninvestable is really driven by the significant underperformance of broad emerging markets, broad China benchmarks, which held–beginning a decade ago–very small weights of growth sectors, and we've been in a growth-geared market. So eventually that exposure gets cut potentially to where it's a de minimis weight.

We don't recommend investors eliminate broad EM exposure. These high commodity and energy prices do benefit the broad benchmark. We believe that to really get more growth exposure within EM, you have to go out and get it. And that's why we created KWEB and KEMQ.

ETF.com: You mentioned that since the financial crisis, there’s been high growth in China growth sectors. That's a historical measure, and a lot of people are looking at China, particularly over the next four to five years, and the government's plan to reshape the economy to emphasize redistribution of wealth and managing inequality. What do you make of that?

Ahern: There’s government intervention risk in all markets. There are a lot of GM bondholders or Fannie and Freddie bondholders who would point to U.S. government intervention.

Regulation isn't necessarily a bad thing. Almost a third of all retail sales [in China] go through the companies within KWEB. Historically, they've not been regulated, and we've seen similar types of regulation in Europe with the GDPR back in 2018.

If we had seen that companies were being materially impacted by regulation, their revenues were declining. But people in China are still using Alibaba, Tencent, WeChat, JD.com. The fundamentals for these underlying companies have been strong, showing that they've adapted to regulation. And that's something that's made the securities very inexpensive, just where the P’s declined, but the E’s increased.

What's happened is our “air pocket” thesis, which is the idea that a lot of investors have stepped to the sidelines. We call it the air pocket thesis, because we've all been on a plane that drops suddenly. They're waiting for a green light to know that the regulation has ended.

The implementation of the regulation has been problematic because it's multifaceted. You have several different regulators involved, and they're each moving at their own pace. It comes off as almost ad hoc or a Whac-A-Mole situation, where a new issue arises almost every week.

We believe we're at the very late innings for this regulation. We saw an important speech from vice premier Liu He on Sept. 6, where he spoke to the importance of the digital and private economy contributing 50% of tax revenue and 60% of GDP, 80% of urban employment. That speech was a very clear indication that they're not trying to kill these companies; they're just so big they need to be regulated, they need to be supervised.

The other green shoots would be that the companies themselves believe they're very inexpensive. Since the end of August, Tencent's been buying about 200,000 shares every day. And during its August conference call, Baidu announced it had bought $3 billion worth of stocks since April 1. Alibaba in its August conference call said it increased its buyback from US$10 billion to $15 billion.

That's a very interesting indication that investors in China who are closest to understanding what's happening are actually buying the stocks today.

Lastly, one of the factors could be that next year's going to be a very important one for China politically. They don't have mandatory retirement for government officials, but it's an implied retirement at age 68, and several of the senior officials within the upper echelon of the Chinese government are going to be around that age. They've had to deal with the trade war, the tech war, then COVID.

If we think about how news is disseminated today, it's not just TV; it's Twitter, it's Facebook, it's YouTube. The same is very much true in China, that the news is disseminated online, not just through online news websites, but their Twitter is Weibo, their Facebook is Tencent's WeChat. You have a variety of online video providers, like Bilibili.

That process to determine who goes, who stays, who are they replaced with [in the Chinese government] starts (this) November. Some elements about the regulation could just be making sure that during this politically sensitive time period, the news around some of these potential changes is disseminated in a way that’s aligned with the government's view.

That could be a bit of a factor why we've seen this regulation implemented in a very short window. But that would also be an indication that if these laws are in effect, and that the companies are abiding by them, that the worst is behind us.

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