Chinese shares are back in play again after years of being dogged and shunned like the ugly stepchild.
So, it’s time to take a dive into what type of ETFs or even share classes look promising. Regarding favorable sectors, the consumer space looks particularly attractive.
Increasing domestic demand and a lessening of the country’s dependence on exports has been a main focal point of the Chinese government’s newest Five-Year Plan (2011-2015), and Chinese officials recently reiterated this point .
Of the various share classes, A-shares focused on mainland Chinese companies have suddenly turned hot again, after the Shanghai Composite Index hit a nearly four-year low just a month ago. Until recently, A-shares were lagging behind the performance of other Chinese share classes, which have been rallying since late summer of 2012.
Targeting Chinese Consumers
The most popular China ETFs offer little to no exposure to the consumer space. The $9 billion iShares FTSE China 25 Index Fund (FXI) has zero exposure to the consumer sectors, while the $1.1 billion SPDR S'P China ETF (GXC) has only 11 percent.
Instead, state-owned mega caps mostly dominate these types of funds. For example, China Mobile, the four big state-owned banks and the three big state-owned energy names make up 52 percent of FXI. Even in GXC—which I consider to be the SPY of China ETFs and currently the best choice for all-around exposure to China—these eight companies constitute 36 percent of the fund.
While there’s nothing inherently wrong with being overweight mega caps, investors preferring more exposure to the growth potential of smaller consumer-focused, nonstate-owned companies do have a number of other ETFs to choose from.
As the name suggests, CHIQ specifically targets the consumer space and holds an assortment of 40 investable Chinese shares from both the consumer cyclical and noncyclical sectors. The fund holds mostly H-shares traded in Hong Kong, but also includes a few U.S.-listed N-shares in the mix.
HAO doesn’t necessarily target the consumer space, but it holds over 200 mid- and small-caps from all investable shares and its consumer cyclical and noncyclical exposure is roughly 25 percent of the fund. The fund has about 40 percent in companies with market caps greater than $2.7 billion, which we consider midcaps.
The iShares MSCI China Small Cap Index Fund (ECNS) is a small-cap fund that holds over 300 companies and has about 28 percent exposure to the two consumer sectors. ECNS is more of a pure-play on small-caps, with 97 percent in companies with less than $600 million in market cap.
Between the two small-cap ETFs, I prefer HAO. I like that it’s able to hold some larger established names like Tsingtao Brewery and the Warren Buffett-backed car maker, BYD. Also, it includes U.S.-listed N-shares in the mix, such as Sohu.com and Youku Tudou.
Since A-shares are mostly uninvestable to foreigners, current fund choices are limited. Still, there are a few options, although they come with some obstacles and additional risks that investors need to weigh.
In the ETF landscape, there’s currently only one option, the Market Vectors China ETF (PEK). This fund tracks the CSI 300 Index through swap agreements with Credit Suisse, a qualified foreign institutional investor (QFII).
However, PEK often trades at a premium to net asset value (NAV) when demand for A-shares jumps and the cost for swaps increase. As of Jan. 4, 2013, PEK was trading at a premium north of 11 percent.
Van Eck was granted QFII status with a quota for $100 million in July 2012, so I expect that at some point in 2013, PEK will become the first U.S.-listed China ETF that holds physical A-shares. Still, it will be interesting to see how Van Eck will mitigate the effects on the premium during any transitional period when PEK switches to holding physical shares.
The actively managed Morgan Stanley China A Share Fund (CAF) is also an option, although it’s a closed-end fund and not an ETF. Still, as a momentum play on the China A-share market, CAF is definitely worth mentioning.
Closed-end funds differ from ETFs because there’s no creation/redemption feature, and thus no arbitrage mechanism in place to bring the fund back to its NAV—so the fund price is at the mercy of market forces.
For a good part of the past few years, CAF has traded at discounts to NAV due to the slowdown in the Chinese economy and a lack of interest in A-shares. Only recently did CAF rocket to a premium again, as demand for A-shares jumped.
Just to show how much CAF can move, compared with the Shanghai Composite’s 15 percent returns from Dec. 1, 2012 to Jan. 4, 2013, CAF has returned 27 percent, juiced by the fund springing back to a premium.
Of course, the flip side can be true as well. If the A-share market cools off or sells off quickly, then CAF can be hit hard, especially if the fund swings from a premium back into a discount.
Ironically, CAF’s premium is currently less than the ETF-structured PEK’s. As of Jan. 5, CAF’s premium was about 5 percent. This just goes to show you the difficulties and limitations of accessing this “uninvestable” A-share market.
For the time being, PEK and CAF are probably better suited for momentum plays rather than long-term investments, although PEK might be interesting once it physically holds A-shares.
From an investment perspective, I still like the consumer space, such as the ETFs I listed earlier.
An Evolving Market
China will also continue to evolve, and so will China ETFs, so investors should be open-minded to new funds that launch in the coming years.
For example, iShares has an A-share fund in filing that’s based on the FTSE A50 Index. Like PEK, the fund will also use swaps.
On the consumer front, there are a few filings on my radar, like the Guggenheim China Consumer ETF. Also, KraneShares, a newcomer in the ETF space, has a pair of consumer-focused ETFs based on CSI indexes in registration, while Van Eck has an ETF focused on consumer discretionary and consumer staples in the regulatory pipeline as well.
At the time this article was written, the author held long positions in CHIQ and CAF. Contact Dennis Hudachek at firstname.lastname@example.org.
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