N-Shares And The Variable Interest Entity Structure
The PowerShares Golden Dragon China Portfolio (NYSEArca: PGJ) is an interesting case because it's only eligible to hold U.S.-listed Chinese shares, or N-shares.
PGJ's holdings consists 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 more depth, since 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).
The investors have ownership in a wholly foreign-owned entity 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 actually 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.1-3
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. Still, recent events have tested investor confidence in this structure.
For example, the recent SEC probe into New Oriental Education & Technology Group's (NYSE: EDU) accounting practices brought the future viability of VIEs into question again.
The day the probe was announced, EDU's shares dropped 34.3 percent. That same day, the N-share-laden PGJ fell more than 4 percent, but MCHI—which excludes N-shares altogether—actually gained 1.8 percent.
Today there's increased speculation about whether the Chinese government (and/or the U.S. Securities and Exchange Commission) will crack down on this structure and tighten regulation on VIEs. While no formal announcements have been made, the perception of N-shares has been somewhat tainted, and it's very possible that the VIE structure could see continued scrutiny for the foreseeable future.
Other China-Heavy ETFs
It's worth discussing several regional or global ETFs with significant China exposure that are subject to the same share class restrictions, based on the indexes they track.
For example, the Vanguard MSCI Emerging Markets ETF (NYSEArca: VWO), the iShares MSCI Emerging Markets Index Fund (NYSEArca: EEM) and the iShares Core MSCI Emerging Markets ETF (NYSEArca: IEMG) track the MSCI Emerging Markets Index. Therefore, all N-shares are excluded.
Even after VWO switches indexes to the FTSE Emerging Index in early 2013, N-shares will still be excluded. However, the "temporary" FTSE Emerging Transition Index that it will track for six months while it winds down its Korea exposure will include P-chips, in anticipation of the reclassification effective March 2013.
The Schwab Emerging Markets Equity ETF (NYSEArca: SCHE) tracks the FTSE All Emerging Index, so it not only excludes N-shares, but also excludes P-chips. This means that until reclassification of P-chips in March 2013, Tencent Holdings, the 12th-largest holding in EEM, is currently missing entirely in SCHE.
Meanwhile, the SPDR S&P Emerging Markets ETF (NYSEArca: GMM) is inclusive of all shares, so Tencent sits as the sixth-largest holding, while Baidu sits as the 12th-largest position.
We see a similar pattern when comparing the three BRIC ETFs, which have an even larger allocation to China.