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Behind the ‘PGJ Incident’

Dennis Hudachek


China's had its share of weirdness in 2012. For example, on the 23 rd anniversary date of the Tiananmen's Square Massacre, the Shanghai Composite fell 64.89 points, an ominous number pointing to the exact date of the actual event, which occurred on June 4, 1989.

While some things can't be explained, the staggering difference in returns a few weeks ago between the PowerShares Golden Dragon China Portfolio (PGJ) and its competitors is explainable.

The PGJ sell-off was originally triggered by the announcement on July 17 by Chinese private education leader New Oriental Education (EDU) that the SEC was investigating its accounting practices.

That day, EDU fell 34.3 percent. PGJ had a 5.4 percent weighting in EDU that morning, so naturally, this would affect the fund's performance. Still, PGJ fell by more than 4 percent—a bit steep for a sell-off in a single 5.4 percent holding. So, there's more to the puzzle than meets the eye.

I've recently blogged about the importance of understanding Chinese share classes in ETFs . While my most recent blog discussed the shortcomings of the iShares FTSE China 25 Index Fund (FXI) and the iShares MSCI China Index Fund (MCHI), PGJ is another great example to discuss.

Simply put, the real culprit behind PGJ's big fall lies in its index methodology and its exclusivity to holding only U.S.-listed Chinese shares, or N-shares.

The Story Behind N-shares

Many Chinese companies engaged in sectors like Internet, media and education, list their shares in the U.S. using a variable interest entity (VIE) structure to circumvent restrictions on foreign direct investment.

N-shares have been a hot topic in recent years because of investor concerns over the somewhat-murky regulatory and legal issues surrounding this VIE structure.

Details of the structure are complex, but in a nutshell, many Chinese companies set up holding companies in foreign jurisdictions (usually in tax havens like the Cayman Islands) and float those shares in the U.S.

The actual operating companies in China (the VIEs), maintain the business licenses and are usually owned by a select few executives—sometimes just the founder. Through contractual agreements, the shareholders and the executives agree to share in the profits of the operating companies.

Many companies have used this structure to list in the U.S., including popular names like Baidu, Sina, NetEase and New Oriental Education. Still, the Chinese government has never actually addressed the legality of this VIE structure and has so far turned a blind eye to it.

Now there's increasing speculation about whether the Chinese government (and/or the SEC) will crack down on this structure and tighten regulation on VIEs.

The SEC's investigation of EDU likely spooked investors in other N-shares. That day, not only did EDU fall, but so did many other heavily weighted N-shares in PGJ's top holdings.



Performance Of Top Holdings In PGJ

On July 17, 2012



Performance (%)

China Mobile












New Oriental Education






Mindray Medical



Focus Media










Notice that China Mobile, CNOOC and PetroChina actually closed the day positive. That's because these holdings are actually ADRs of H-shares (or Red chips) that trade in Hong Kong, as opposed to the other names that list strictly in the U.S. using VIEs (sometimes ADRs of H-shares are also included in the N-share mix).

So, a majority of the carnage was focused on companies using the VIE model. FXI and MCHI were mostly spared from the carnage because they aren't eligible to hold N-shares. FXI closed the day up 2.3 percent, while MCHI closed the day up 1.8 percent.

The SPDR S'P China ETF (GXC) holds all investable shares, including N-shares. But less than 10 percent of its portfolio is weighted in N-shares (with Baidu making up 5 percent of that). This limited the downside impact on GXC, which ended the day up 1.3 percent.

I should note here that just because MCHI doesn't hold N-shares, it isn't completely immune from the "VIE" stigma. Tencent Holdings, a top holding in MCHI, also uses this structure, but it lists in Hong Kong. On that brutal July 17, Tencent fell 2.2 percent.

Questions Remain Surrounding N-shares

So, does an SEC investigation into EDU mean all VIEs will be investigated? Furthermore, if the Chinese government decides to crack down on the VIE structure, will it target companies already listed, like Baidu and Sina, or will they simply restrict new companies from listing this way?

These are questions that no one knows the answers to. While the cause for concern is legitimate, it's too early to make an assumption that all N-shares are doomed.

While there are unknowns regarding N-shares, they often represent companies in high-growth sectors that play a significant role in China's growing economy.

FXI and MCHI may have been spared from the July 17 fallout, but these funds are also limited in scope because they aren't eligible to hold N-shares.

Therefore, rather than speculating on the outcome of the investigation, it's important to stay diversified. This means it continues to make sense to hold funds that are eligible to hold all "investable" shares, like GXC or Guggenheim China All-Cap ETF (YAO).

This would give you exposure to the most significant Chinese companies, while limiting the downside in case there is a crackdown on N-shares, or for that matter, unexpected changes in any type of shares.

With China investing, there's always extra homework that's needed. I can't stress enough the importance of understanding Chinese share classes in your hunt for the right China ETF.

At the time this article was written, the author had no positions in the securities mentioned.

Contact Dennis Hudachek at dhudachek@indexuniverse.com.


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