Table of Contents
- 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: 2015 and Beyond
Selecting the best China ETF just got even trickier. There are now more than 30 U.S.-listed China equity ETFs to choose from, capturing different markets and 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.
Foreign investment is still being largely restricted in China, so there are multiple share classes of Chinese companies floating around on various exchanges. As a result, most China ETFs capture only a piece of the entire China equity pie.
Therefore, China investors have to first ask themselves, which Chinese market am I buying?
It's crucial to understand that China ETF investing is still largely a tale of two markets: "onshore" and "offshore." The differences in the returns between the markets can, at times, be in the hundreds, or even thousands, of basis points.
Since Chinese share classes, especially as they relate to ETFs, are often misunderstood—or worse, ignored altogether—we at ETF.com 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 onshore securities, or "A-shares."
Due to this restriction, most U.S.-listed ETFs currently hold shares of Chinese companies listed offshore 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" offshore shares.
For example, the iShares China Large-Cap ETF (FXI), which tracks the FTSE China 50 Index and holds 50 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 Alibaba and Baidu, two of China's Internet behemoths, are excluded because they're 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/or 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.
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) also exclude many significant N-shares beyond Alibaba and Baidu, such as SINA, JD.com, Ctrip.com, Qihoo 360 Technology, Weibo, NetEase and Youku Tudou.
Therefore, China ETFs that track FTSE and MSCI indexes are currently 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).
(Note: On Sept. 4, 2014, weeks before the Alibaba IPO, MSCI launched an official consultation with investors to address the issue of N-share inclusion into its Global Investable Market Index (GIMI) series. As a result of that consultation, MSCI announced on Jan. 15, 2014, that N-shares will be included in its indexes. Changes are expected to be implemented in November 2015).
For investors looking for comprehensive "Total China" coverage, Deutsche Asset & Wealth Management broke new ground in April 2014 with its Deutsche 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 ETFs, the Deutsche X-trackers Harvest CSI 300 China A-shares ETF (ASHR) and the Deutsche X-trackers Harvest CSI 500 China A-Shares Small Cap ETF (ASHS), for its A-shares component of the fund.
For investors looking to get a broad mix of investable Chinese shares, the SPDR S&P China ETF (GXC) holds all investable shares, providing comprehensive "offshore" exposure to the Chinese market.
The PowerShares Golden Dragon China ETF (PGJ) 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., most of which 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. Since then, hundreds of other Chinese companies listed using VIEs, and continue to do so today. More recently, Alibaba's high-profile IPO really brought this discussion front and center to investors who previously were not familiar with this structure.
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.
Since then, the number of RQFII hubs has expanded significantly. Besides the U.K., Germany, France and South Korea were awarded 80 billion yuan quotas. Switzerland and Australia were awarded initial quotas of 50 billion yuan. Qatar also joined the club with an initial 30 billion yuan quota.
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 Deutsche 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), which formerly used swap agreements with QFIIs to track the CSI 300 Index; and the PowerShares China A-Share ETF (CHNA), which uses futures contracts to gain exposure to A-shares.
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). In May, Deutsche launched a small-cap version of ASHR, the Deutsche X-trackers Harvest CSI 500 China A-Shares Small Cap ETF (ASHS), which captures 500 small-caps from the broader CSI 800 Index.
Most recently in July 2014, Van Eck launched the Market Vectors ChinaAMC SME-ChiNext ETF (CNXT), which captures 100 small- and medium-sized companies listed on the SME and ChiNext Boards on the Shenzhen Stock Exchange. CNXT's launch brought the number of U.S.-listed RQFII equity ETFs to five.
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, RQFII-licensed firms are still bound by quotas, which are granted by SAFE.
If a fund hits its quota, it will need to reallocate more quota from another fund, or request a quota increase from SAFE. If the fund cannot obtain more quota in sufficient time, it may have to resort to derivative products or even limit or 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 Vanguard FTSE Emerging Markets ETF (VWO) tracks a FTSE index, and the iShares MSCI Emerging Markets ETF (EEM) tracks an MSCI index, so N-shares are excluded from these funds (though EEM is expected to include them beginning November 2015).
Meanwhile, the SPDR S&P Emerging Markets ETF (GMM) tracks an S&P index, so it's inclusive of all investable, offshore China shares.
We see a similar pattern when comparing BRIC-themed ETFs, which have even larger allocations to China.
The iShares MSCI BRIC ETF (BKF) has a 38 percent weighting in China. But again, since it tracks an MSCI index, investors won't find any N-shares here, at least for now.
The Guggenheim BRIC ETF (EEB) is an extreme case, as it's only eligible to hold depositary receipts and N-shares. This means its 40 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) is inclusive of all Chinese shares, and carries a massive 67 percent weighting in China. From a Chinese exposure perspective, BIK is the most comprehensive.
In just 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.
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 have a market cap of roughly $1.35 trillion, which accounts for about 57 percent of China's $2.35 trillion market cap in MSCI's All-China 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 22 percent. In the FTSE Emerging Markets Index, tracked by VWO, China represents roughly 24 percent.
If A-shares were fully incorporated into MSCI's flagship EM index with no quota restrictions, it would likely account for more than 30 percent of the index (if South Korea, which carries a 15 percent weighting, is reclassified as a developed nation, China's weighting is likely to become even higher).
MSCI is reviewing the inclusion of A-shares. If it's announced that A-shares will begin being included in the index in May 2015, the full transition will likely be gradual, taking effect over the course of several years.
On Nov. 17, 2014, the long-awaited Shanghai-Hong Kong Stock Connect officially commenced. The new pilot program permits cross-exchange trading between Hong Kong and Shanghai, up to a specific daily quota.
Currently, the daily quota is a combined 23.5 billion yuan ($3.8 billion). It's expected that this quota will be increased gradually over time.
Investors in mainland China have a daily quota of 10.5 billion yuan and are eligible to trade constituents of the SSE 180 and 380 indices, as well as Shanghai/Hong Kong dual-listed shares.
Hong Kong-based investors have a daily quota of 13 billion yuan and are eligible to trade constituents of the Hang Seng Composite Large & Midcap indices, as well as Shanghai/Hong Kong dual-listed shares.
In January 2015, Chinese officials confirmed that a similar stock connect program between Hong Kong and Shenzhen was in the works. The Shenzhen-Hong Kong Stock Connect is expected to commence in the second half of 2015.
RQFII Bond ETFs
Just as we've seen innovation on the equity front, the China fixed-income ETF market has seen its share of innovation. Through the RQFII scheme, U.S. investors can now gain exposure to China's roughly $5 trillion mainland bond market, the third-largest in the world after the U.S. and Japan.
On Nov. 10, 2014, Van Eck broke new ground by launching the first U.S.-listed RQFII bond ETF, the Market Vectors ChinaAMC China Bond ETF (CBON). The fund targets investment-grade sovereigns and corporates traded on exchanges in mainland China.
Only a week later, Global X launched the GF China Bond ETF (CHNB), the first U.S.-listed RQFII bond ETF with access to China's interbank bond market, where more than 90 percent of all bond trading occurs in China. CHNB targets investment-grade sovereigns and enterprise bonds, which are bonds issued by state-owned enterprises.
Finally, in early December 2014, KraneShares broke new ground by launching the first U.S.-listed commercial paper ETF. The KraneShares E Fund China Commercial Paper ETF (KCNY), which also has access to the interbank market, targets the investment-grade commercial paper market in China.
There seems to be institutional interest in China's mainland bond market. All three ETFs seeded with far more than the standard $2.5 million in capital that's typical with new ETFs.
Mainland bonds are thought to be coveted for their plump yields, especially at the shorter end of the yield curve, and because they're less correlated to global bond markets. Shareholders are also fully exposed to the renminbi relative to the U.S. dollar.
The launch of ASHR, PEK and KBA were only the tip of the iceberg. Since then, we've seen the launch of ASHS and CNXT in the equity space, as well as CBON, CHNB and KCNY in the fixed-income space.
Many more RQFII ETFs are planned and expected to launch in the coming years.
Deutsche X-trackers has a total of seven sector-focused ETFs in the pipeline. Van Eck also has a suite of RQFII ETFs lined up, including a small-cap fund, and a consumer- and dividend-focused ETF, and an "all China" ETF based on the MSCI All China Index. It remains to be seen whether or not this "all China" ETF will use the RQFII scheme.
Hong Kong-based CSOP Asset Management has the CSOP FTSE China A50 ETF in the works. The fund will track the most liquid A-share index in the world, the FTSE China A50 Index. Teamed up with Source, CSOP has already launched a FTSE China A50 RQFII ETF 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.
On the fixed-income front, Deutsche X-trackers is expected to launch an aggregate RQFII mainland bond ETF, while KraneShares has in filing a currency-hedged version of KCNY.
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, it's expected that investors will have several more options 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 continue to see a host of 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.
|US-Listed China Equity ETFs|
|Fund Name||Ticker||Index||Share Classes|
|iShares China Large-Cap||FXI||FTSE China 50||H, Red Chips, P-chips|
|iShares FTSE China||FCHI||FTSE 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|
|Deutsche X-trackers Harvest MSCI All China Equity||CN||MSCI All China||A (ETF), H, B, Red Chips, P-chips, N|
|Deutsche X-trackers Harvest CSI 300 China A-Shares||ASHR||CSI 300||A (RQFII)|
|Deutsche X-trackers Harvest CSI 500 China A-Shares Small Cap||ASHS||CSI 500||A (RQFII)|
|Market Vectors China AMC A-Share||PEK||CSI 300||A (RQFII)|
|Market Vectors ChinaAMC SME-ChiNext||CNXT||SME-ChiNext 100||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 50||H, Red Chips, P-chips|
|ProShares Ultra FTSE China 50||XPP||FTSE China 50||H, Red Chips, P-chips|
|Direxion Daily FTSE China Bear 3X||YANG||FTSE China 50||H, Red Chips, P-chips|
|ProShares Short FTSE China 50||YXI||FTSE China 50||H, Red Chips, P-chips|
|RQFII Equity ETFs in the Pipeline|
|Fund Name||Ticker||Index||Share Classes|
|Deutsche X-trackers Harvest China A-Shares Industrial||ASHI||CSI 800 Industrials Index||A (RQFII)|
|Deutsche X-trackers Harvest China A-Shares Technology||ASHK||CSI 800 Technology Index||A (RQFII)|
|Deutsche X-trackers Harvest China A-Shares Materials||ASHB||CSI 800 Materials Index||A (RQFII)|
|Deutsche X-trackers Harvest China A-Shares Health Care||ASHV||CSI 800 Health Care Index||A (RQFII)|
|Deutsche X-trackers Harvest China A-Shares Financial||ASHF||CSI 800 Financials Index||A (RQFII)|
|Deutsche X-trackers Harvest China A-Shares Consumer Staples||ASHP||CSI 800 Consumer Staples||A (RQFII)|
|Deutsche X-trackers Harvest China A-Shares Consumer Discretionary||ASHY||CSI 800 Consumer Discretionary||A (RQFII)|
|CSOP FTSE China A50||TBD||FTSE China A50 Index||A (RQFII)|
|Market Vectors All China||ALCH||MSCI All China Index||A (TBD)|
|Market Vectors China A Small-Cap||TBD||TBD||A (TBD)|
|Market Vectors China A Consumer Demand||TBD||TBD||A (TBD)|
|Market Vectors China A Quality||TBD||TBD||A (TBD)|
|Market Vectors China A Quality Dividends||TBD||TBD||A (TBD)|
|Deutsche X-trackers Harvest China Bond||TBD||TBD||Bond (RQFII)|
|KraneShares E Fund China Commercial Paper Hedged||KEEP||CSI Diversified High Grade Commercial Paper Hedged Index||Bond (RQFII)|
- 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 , CBON and KCNY. Contact Dennis Hudachek at [email protected], or follow him on Twitter @Dennis_Hudachek.