Therefore, ETFs that track FTSE's China indexes, such as FXI, are only eligible to hold H-shares and red chips, which limit their scope, as the indexers' classification methodology determines where that company sits in their global breakdown.
The iShares FTSE (HK Listed) Index Fund (NYSEArca: FCHI), a "total market" version of FXI with over 120 holdings, is in a similar boat. So again, it misses out on important P-chip names like Tencent Holdings, Belle International, Want Want China, Gome Electronics and Geely Automobile.
It's worth noting that on June 18, 2012, FTSE announced that it will reclassify P-chips from Hong Kong to China in their FTSE Global Equity Series, effective March 2013. Then on Sept. 26, 2012, it extended that reclassification announcement to its FTSE China 25 Index. This means that P-chips, such as Tencent, should be eligible for inclusion into FXI once this reclassification takes effect in March 2013.
MSCI's scope is slightly wider than FTSE because its indexes are eligible to hold P-chips. Still, MSCI does not include N-shares in its indexes. According to MSCI's methodology, a security's country classification is determined by the location of its incorporation and primary listing.
Many N-shares are incorporated in tax havens like the Cayman Islands or Bermuda, and have their primary listings in the U.S. (N-shares and the regulatory and legal risks associated with them are discussed in detail below).
Therefore, ETFs like the iShares MSCI China Index Fund (NYSEArca: MCHI) provide exposure to mega-cap P-chips like Tencent Holdings, but exclude many significant N-share technology names like Baidu, Sina and NetEase. This example also shows that significant sector biases result from the share-class issue.
Investors looking to get a broad mix of all investable Chinese shares have options, such as the SPDR S&P China ETF (NYSEArca: GXC). The $875 million GXC holds all investable shares, providing the most comprehensive exposure to the Chinese market currently available to U.S. investors.
Other cap-weighted options that provide comprehensive share-class exposure include the Guggenheim China All-Cap ETF (NYSEArca: YAO) and the Guggenheim China Small Cap ETF (NYSEArca: HAO). Global X's suite of China sector ETFs also pulls its holdings from a universe of all investable shares.
A-shares aren't entirely inaccessible to ETF investors. Those looking to dive into the A-share market have one option: the Market Vectors China ETF (NYSEArca: PEK), which enters into swap agreements with QFIIs, in order to track the CSI 300 Index. But investors in PEK need to weigh some factors.
First, because it utilizes a swap agreement, the fund comes with counterparty risk. PEK currently has one swap counterparty, Credit Suisse. This means if Credit Suisse fails as a company, or fails to deliver on its end of the deal, the shareholders could be affected.
PEK's counterparty also gains access to A-shares as a QFII, and QFIIs have quotas (currently $1 billion per institution). So when demand is especially strong for A-shares, swaps get more expensive—which can cause the fund to trade at premiums to its net asset value.
From its inception in late 2010 until August 2011, PEK often traded at premiums north of 10 percent. As China eventually increased its QFII quotas and demand for A-shares decreased with the slowdown in Chinese growth, premiums have since fallen.
It's worth noting that in July 2012, Van Eck Associates was granted QFII status for $100 million, meaning it will likely be the first U.S.-based ETF provider to have a physically backed China A-share fund.
When this change is implemented, it should alleviate the premium issue significantly until that $100 million quota is reached. Investors should stay tuned for further developments from Van Eck.