The word “China” – evokes a number of thoughts in peoples’ minds: “a country with a population of 1.3 billion”, “an emerging market with attractive investment opportunities”, “one of the fastest growing economies in the world”, etc. However, when it comes to the Chinese equity market, given its regulatory structure and legacy matters, China continues to maintain tight capital controls and the domestic equity market is not entirely open to foreign investors. This has resulted in a variety of different types of investment channels/markets providing different types of access to “China”, including the ETFs tracking different Chinese indices.
With our launch of research coverage on Asian ETFs listed in Hong Kong and Singapore, we are now offering individual research reports on ETFs that in total represent over 85% of the total AUM of locally listed ETFs. In general, we find that the key Chinese equity indices tracked by local ETFs tend to have concentrated exposure in the financial services sector (around 30-60%, comprised mainly of bank shares). ETFs that track domestic Chinese equity indices tend to use synthetic replication to obtain access to the A-Share market; while physical replication ETFs are available for non-domestic Chinese equity indices. While both the domestic and non-domestic “China” markets should be inherently driven by the same fundamental factors, differences in index composition and the constituents’ listing locations result in different risk/reward profiles for investors. This is the very reason that investors should know what flavour of “China” they want to achieve exposure to before investing.
We believe that there is no “best” exposure when it comes to Chinese equity benchmarks, but that some might be a better fit than others. Ultimately, the answer to which is better depends on each investors specific objectives. We hope this analysis in combination with our research reports on the individual ETFs offering exposure to Chinese equity indices will help investors to select the “best” ETF to gain access to Chinese equities.
What is “China”?
Defined in very general terms, Chinese equities are issued by companies doing business in the PRC. More granularly, Chinese companies listed in different markets are classified under different share types/names, depending primarily on whether they are incorporated in or outside of China. Namely, these classifications include A-Shares, B-Shares, H-Shares, Red chips, and P Chips. A summary of the classifications is as follows:
- A- Shares: Companies incorporated in China which trade on the Shanghai and Shenzhen stock exchanges. They are quoted in Renminbi (RMB) and only domestic Chinese investors and Qualified Foreign Institutional Investors (QFIIs) are able to invest directly in the A-Share market.
- B-Shares: Companies incorporated in China which trade on the Shanghai and Shenzhen stock exchanges. They are quoted in foreign currencies (Shanghai: USD; Shenzhen: HKD) and are open to foreign investors.
- H-Shares: Companies incorporated in China which trade on the Hong Kong Stock Exchange. They are quoted in HKD and open to international investors. Note that many companies with H-Share listings also have A-Share listings.
- Red chips: Companies incorporated outside of China which trade on the Hong Kong Stock Exchange, ontrolled by organisations or enterprises that are owned by the state, provinces, or municipalities of the PRC.
- P-Chips: Companies incorporated outside of China which trade on the Hong Kong Stock Exchange and satisfy the following critria:
- The company is controlled by PRC individuals
- The company derives more than 80% of its revenue from PRC China
- The company allocates more than 60% of its assets in PRC China
Note: The above are MSCI classifications which serve as a general guideline. Different index providers may classify them slightly differently. There are also other references to N-Shares (firms incorporated in China, with listings on the NYSE or NASDAQ) and S-Shares (incorporated in China and listed in Singapore).
Total Market Capitalisation of Hong Kong and China Markets
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Index Composition for Major Indices and the ETFs that Track Them
There are numerous indices that track the different “flavours” of “China”. Here we offer a summary of the key indices:
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From the above summary, we can see that:
- Indices tracking Chinese equities are composed quite differently and have very different historical returns and risk profiles.
- All of these indices have a large concentration in the financial services sector, with the majority of this exposure being comprised of the shares of Chinese banks, at 30-60%.
- Domestic Chinese indices have similar key constituents, but place different weights on them depending on each index’s construction methodology. The same applies to the non-domestic Chinese indices.
- Domestic Chinese indices have shown higher volatility and similar returns over the trailing 3-year period than non-domestic Chinese indices; but have exhibited lower volatility and higher returns over the trailing 1 year period.
Correlation Matrix .png)
- As can be seen in the correlation matrix above, domestic and non-domestic Chinese equity indices have shown only a moderate level of correlation to each other(~80% during the past year; ~70% over the past 3 years).
- The correlation between domestic and non-domestic Chinese equity indices seems to have strengthened in the past year as compared to the trailing 3 year period.
- Domestic Chinese equity indices have recently exhibited a lower degree of correlation with world equity indices (~50-60% over the trailing 1 and 3 year periods) versus non-domestic Chinese indices (70-90%). This suggests that ETFs tracking domestic Chinese equity indices have been better diversifiers for global investors than those benchmarked to non-domestic shares.
Fundamental Drivers of the Chinese Equity Market
The Chinese equity market is obviously driven mainly by investors’ expectations of the future performance of the Chinese economy, as well as other factors such as the fluctuation of the Renminbi (RMB), which we have discussed in detail in our “Meet the Indices” article series. Here is a summary of the key fundamental forces driving the Chinese economy as well as the key sectors within the various Chinese equity indices:
Sector | Description | Key Driving Forces or Concerns |
Financial Services | Mainly banks and insurance companies | - The reserve requirement ratio for banks has been lowered 3 times since December 2011
- Interest rate cut by 25bps in June 2012, first time in 3.5 years
- Signs of slowing loan growth
- “Current bank monopoly must be broken up”, said Premier Wen
|
Energy | Mainly oil companies | - Exposed to global energy prices
- Subject to Chinese regulations in the energy sector
- Any overseas expansion strategies?
|
Basic Materials | Coal companies and metal miners/producers | - Subject to export demand and domestic growth
- Coal companies are subject to global energy prices
- Chinese growth slows?
- Chinese government stimulates the economy?
- More infrastructure construction?
|
Communication Services | Industry behemoth China Mobile (00941) is by far the biggest player in this sector | - Subject to local regulation
- Rapid technological changes
|
Industrials | Companies that manufacture machinery, hand-held tools and industrial products | - Subject to export demand and domestic growth
- Chinese growth slows?
- Chinese government stimulates the economy?
- More infrastructure construction?
|
Potential Risks in ETFs with a “China” Label
Domestic versus Non-domestic: Domestic Chinese stocks often trade at a premium to their non-domestic counterparts. We can see evidence of this by examining the Hang Seng China AH Premium Index, which tracks the average price difference of A shares over H shares for the largest and most liquid Chinese companies with both A-share and H-share listings. The index stood at 106 as of end-April 2012, and had a 52 week range of 95.51 to 142.07. We believe that recent steps taken to further open the domestic Chinese equity market, such as the increase in QFII quotas, will serve to move the AH Premium Index closer to its theoretical “fair” level of 100. This would imply a further increase in the level of correlation between ETFs tracking the domestic and non-domestic Chinese equity markets.
Diminishing Premiums for Synthetic ETFs Offering A-Share Access: Currently there are no physical replication ETFs offering exposure to the Chinese A-Share market. However, there are a number of synthetic ETFs which use access products or swaps, to gain access. Foreign investors in A-Shares are subject to QFII quotas and the access product/swap counterparty(ies), being a QFII, have their own quota limits. Once these quotas are reached, these counterparties may not be able to hedge their positions, resulting in their inability to issue additional access products/swaps and potentially disrupting the creation and redemption process. This could lead the ETF’s market price to stray from its net asset value (NAV). Investors should note that changes to the QFII regulations in China may be made at any time by the Chinese government. In April 2012, the CSRC raised the QFII and RQFII quotas from US$30bn to US$80bn and from Rmb20bn to Rmb70bn, respectively. In addition, the CSRC has also allowed RQFIIs to issue ETFs which invest directly in A-Shares. These ETFs are likely to be listed in Hong Kong soon.
Tax: Under Chinese corporate tax rules, a 10% withholding tax may be charged on the gains derived from the sale of A-Shares by QFIIs. However, withholding tax has only been enforced on dividend and interest payments from PRC listed securities. The State Administration of Taxation has not collected and has expressed its intent to collect the tax that applies to sales of A-Shares held by QFIIs. Different ETFs tracking domestic Chinese equity indices have different accounting policies, where only some have provided for the withholding tax (i.e. deducted the tax from the ETF’s NAV). Investors should be aware that (1) if tax is to be collected: the NAV of those ETFs which have made a provision for the tax would not be affected while the NAV for those ETFs which have not made a provision for the tax would be reduced; or (2) if the tax is not to be ultimately collected: the NAV of those ETFs which have made a provision for the tax would increase while the NAV for those ETFs which have not made a provision for the tax would not be affected.
Our Research Coverage on Asian ETFs Listed in Hong Kong and Singapore
We are now covering research on the following ETFs. Our wide range of research has allowed us to draw broad comparisons amongst locally listed ETFs and give global context where appropriate by leveraging the knowledge and experience of our global ETF research team: