China A-Share ETFs Not In Line Of Fire

The ongoing sell-off in China’s mainland stock market this week has been so steep, circuit breakers were triggered and trading halted completely twice in four days.

Yesterday morning, the market was open less than 15 minutes before a 7% decline had all trading stopped for the day. The very circuit breakers that were designed to help minimize losses are now being blamed for exacerbating them, and Chinese regulators have stepped in and suspended their use.

George Magnus, senior economic advisor to UBS, offered a great explanation of what’s happening in China’s stock market this week and the challenges it faces going forward. It’s worth a read.

Fleeting Confidence

The gist of Magnus’ assessment is that China’s problems go deeper than whether circuit breakers work in mitigating market volatility. According to him, there’s growing lack of investor confidence due to several factors, such as ineffective government intervention in the market; worsening “indebtedness and slowing growth;” economic reforms that are, as he put it, “stuck in the mud;” and concerns—not to say confusion—over the country’s currency policies, which have now put the yuan in a downward path.

All of these factors have many investors looking for the exits, helping push China’s A-share market—stocks that trade on the mainland exchanges—sharply lower.

“It’s hard to see an immediate end to turbulent market conditions, or the attainment of lasting stability while many of the uncertainties I’ve alluded to persist,” Magnus concluded. “And persist they will.”

But to U.S. ETF investors who own funds allocated to mainland Chinese stocks such as the Deutsche X-trackers Harvest CSI 300 China A-Shares ETF (ASHR | F-54), for example, the latest turmoil in China’s market may be insignificant longer term.

That’s because U.S.-listed funds already trade when Chinese markets are closed. ASHR is tied to the same index circuit breakers that are tied to the CSI 300, and it has $370 million in total assets. The fund has seen an average of $63 million trade hands every day. The ETF offers exposure to China’s most liquid stocks listed on the Shanghai and Shenzhen exchanges.

Thursday morning, ASHR traded some 5% lower on the heels of the latest market decline, putting its losses in the first week of the year at roughly 12%. But the fund has been trading efficiently, with pennywide spreads.

In the past 12 months, the fund has declined 15.6%, as the chart below shows:

Chart courtesy of StockCharts.com

Disruptions ‘Settle Out’

“China is always closed when ASHR is trading, so it will always look like it’s trading at a premium or discount, no matter what happens in the Chinese local market,” Dave Nadig, director of ETFs at FactSet, said. “But as we’ve seen with other international disruptions like Greece and Egypt, it tends to settle out in the end.”

In a fund like ASHR, intraday net asset value is basically irrelevant, since the Chinese local market isn’t open when ASHR is trading. What matters when evaluating the fund is whether premiums and discounts—deviations from the underlying—persist over long periods of time. And so far, ASHR is behaving just as it should.

ASHR ‘Passing The Test’

The caveat here would be if Deutsche Bank were to freeze creations/redemptions in ASHR when China shuts its stock markets. That would prevent U.S. investors from getting in and out of the fund.

Could it happen? Technically, yes. But it’s unlikely, according to Dodd Kittsley, head of ETF Strategy at Deutsche Bank. The company has no plans of doing that.

“We have designed our fund to work around the high level of suspended stocks that typically occurs in the A-share market,” he said. “And we have gone through quite a bit of volatility, and passed that test with flying colors.”

ASHR, unlike most ETFs, is not an in-kind fund. It is a cash-create fund. That means the buying in the underlying securities can be done over a period of time—a design that was deliberately chosen due to the challenges of acquiring A-shares and fulfilling trades.

Remember that it wasn’t until November 2013 that exposure to A-shares through an ETF was even made possible. ASHR was the first fund to offer access to a market that’s relatively new to ETFs, and still improving in terms of accessibility and still maturing.

Cash Redemptions Will Happen, No Matter What

Deutsche has also set up a credit facility to meet cash redemptions whether security trading is halted or not; again, a design meant to meet the challenges of navigating the A-shares market. In the past 12 months, ASHR has seen some $572 million in net redemptions, according to ETF.com data.

“A very positive development for the market was news that they are getting rid of the circuit breakers, which was a regulatory test that didn’t have the intended positive consequences,” Kittsley added.

Contact Cinthia Murphy at [email protected].