Chinese ETFs Trading On “Best Guess” Basis

Exchange traded funds (ETFs) tracking Chinese equities have been hit with large price swings and gaps in valuation as many stocks suspend trading, with one industry expert saying that Chinese ETFs are left trading on a “best guess” basis.

Over half of all Chinese-listed stocks on the Chinese markets have halted secondary market trading to minimise panic selling and massive outflows, and this is causing problems for ETFs tracking these indexes, across both mainland and offshore markets.

The Shanghai Composite Index fell 32 percent from 12 June to 8 July, and has rebounded over 11 percent until 14 July.

Nevertheless, the stock suspensions caused significant price swings as many ETFs were trading despite holding frozen shares or derivatives. Chinese trackers have also seen double the trading volumes over recent weeks.

ETF Disruptions

All five physically replicated A-shares ETFs were trading at a wider than average discount yesterday, compared to a premium of over 6.5 percent just last week. Similarly, synthetic China ETFs from Lyxor and db X-trackers have moved to even wider discounts of up to 4 percent as of 14 July, according to Bloomberg data.

Marco Montanari, Deutsche Asset & Wealth Management’s head of passive investments, Asia-Pacific, mentioned that discounts can arise as the ETFs operate in a different time zone, and added: “Also, when the underlying stocks owned by the ETF are suspended, the ETFs may be priced by market-makers and investors making specific assumptions on the price at which these suspended stocks may trade. This also contributes to price discovery and can be another reason for premiums and discounts."

The Source CSOP FTSE A50 UCITS ETF has been “relatively stable”, according to a spokesperson, with only a handful of underlying companies closed, but has seen spreads widen from normal averages of around 0.40 percent to about 0.70 percent.

Meanwhile, a spokesperson from ETF Securities, which also runs an A-share ETF, said: “As many stocks were suspended for trading, a NAV valued against stale prices cannot be used as a fair benchmark to evaluate the market price premium and discount.”

Fundamentally Broken The Market

Dave Nadig, vice president, director, exchange traded funds at FactSet, wrote in a blog for ETF.com this week the following list of “nearly inconceivable interventions” that have happened in just a few weeks, and how they've fundamentally broken the way the market is supposed to work:

1)  “Countless stocks have ceased trading. Many are scheduled to resume trading at the end of the month, but obviously there are no guarantees. Many of the top holdings in popular small-cap ETFs [like the Europe-listed iShares MSCI China A UCITS ETF (CNYA), which tracks an index of 577 stocks] haven't traded in weeks at this point, meaning any transactions you make, and any NAVs published, will be based on "best guesses" by both the market and the fund accountants with the unfortunate job of having to come up with a price for a closed security.

2) “Institutions holding more than 5 percent stakes in Chinese companies have been locked out of selling. While this doesn't affect any ETFs I could find (even the heavily indexed Hong Kong stocks have less than a few percent held by the major indexers), it fundamentally breaks the supply and demand relationship for shares, artificially inflating prices.

3) “The Chinese government is now actively supporting buying stocks on margin, making funding available expressly for this purpose. Honestly, I find this a terrifying proposition. Does anyone believe the "fair" price of a Chinese timber company will be sussed out by someone who was just given a gambling stake?

4) “Chinese retirement funds can now invest up to 30 percent of their assets in stocks. On the surface, this sounds like pretty rational Western-style investing, but it also will likely result in a short-term buying spree that doesn't actually aid in price discovery.

5) “Just this week, regulators have said that banks can loan money to companies using company stock as collateral. To my mind, this actually puts the entire mainland banking sector at risk, and is precisely the kind of degraded capital structure Western regulators have been railing against for decades.”

Andrew Swan, head of Asian equities for the fundamental equity group at BlackRock, took a more positive view on the longer term and on Government intervention.

“One really important factor is that in a high leverage environment governments are going to look for new sources of growth, and one of those is structural reform,” he said on a webinar on 14 July.

“So while we are well aware of risks, people don’t really appreciate the changes that are coming, the reforms, and that’s one of the benefits of its political system, it can force change,” he added.