A version of this article first appeared in the “Morningstar's Guide to Investing in Chinese Equities via ETFs”.

We have often received from a wide variety of investors on a host of topics pertaining to Chinese equity ETFs. Here, we have chosen the 10 most important questions that we believe every investor should be able to answer before investing in Chinese equity ETFs.

Q:        What should be my thought process when I am deciding amongst Chinese equity ETF(s)?
A:         We illustrate our recommended decision making process in the following flow chart

Q:        Do I need Chinese equity ETF(s) in my portfolio?
A:         It depends. If an investor has a positive view on Chinese equities, Chinese equity ETFs are certainly good tools for gaining exposure. From a broader portfolio perspective, Chinese equities generally have a moderate degree of correlation to other equity markets, including Chinese equity ETFs in a portfolio will likely have diversification benefits for international investors. 

Q:        If I wish to obtain exposure to Chinese equities, does listing location matter?
A:         The listing location of an ETF has a number of important implications, including but not limited to trading hours, liquidity and tax treatment. Trading hours may be a more important consideration for retail investors, given that they will most likely execute trades on local exchanges. In our view, for long term investors considering two otherwise identical ETFs trading on different exchanges, choosing between the two will hinge on the relative cost of transacting in their shares, while accounting for differences in trading rules and regulations. As for tax implications, we would advise investors to consult their tax advisers, especially when choosing ETFs listed on foreign exchanges.

            Other factors, such as the underlying index, liquidity, and bid-offer spreads should also be considered when choosing an ETF, irrespective of where the ETF is listed.

Q:        Should I choose an ETF with A-Share (onshore) exposure or non-A-Share (offshore) exposure?
A:         Theoretically, Chinese stocks with both onshore and offshore listings should trade at the same price and should perform similarly over the long term. However, seemingly similar indices could have markedly different compositions based on the availability (or lack thereof) of different stocks in the onshore and offshore markets (not all stocks, in fact very few, are dual-listed), which then will result in different risk/return profiles for these indices. Taking this another step further, at the ETF level, A-Share ETFs are exposed to capital gains tax uncertainty, which will also have noticeable effects on the relative performance of funds tracking similar indices.

Q:        Does the choice of index matter?
A:         In general, yes. The index dictates the exposure of the ETF including specific stock exposure, sector exposure and on/offshore China exposure. It is these factors that translate into the different risk/return profiles of ETFs. We advise investors to understand how these factors affect an ETF’s exposures before investing.

Q:        If an ETF is trading at a premium to its NAV is it an indication that the market price of the ETF will continue to rise?
A:         During regular trading hours, in normal market conditions, when the creation/redemption process is operating smoothly, an ETF usually trades very closely to its NAV. However, for A-Share ETFs, when a counterparty’s QFII quota or its own RQFII quota limits are reached, additional demand for the ETF units will push the ETF’s share price to a premium to its NAV. The level of the premium will reflect the level of additional demand. If additional demand remains constant, the market price of the ETF will move along with the underlying index at a stable premium.

            For Chinese equity ETFs trading when the underlying market is closed, premiums and discounts will reflect overnight market movements in Asia, as well as any market moving news during U.S. and non-overlapping European market hours.

            Overall, ETF premiums and discounts should be analysed according to the specific circumstances facing the investor and fund in consideration.

Q:        Very often I see persistent premiums in A-Share ETFs, what are the reasons/drivers behind this?
A:         Quota-related issues tend to be the key factor underlying persistent premiums. QFII counterparties for synthetic ETFs and the managers of RQFII ETFs are subject to QFII/RQFII quotas. In the case that the counterparty’s or manager’s quota is reached and additional quota is either not granted or not granted in time, unit creations could be disrupted and the ETF could trade at a premium.

Q:        Is low TER a comprehensive measure of the cost of owning ETFs?
A:         In short, no. When analysing ETFs, investors should take a holistic approach to assessing the total cost of ownership. Beyond the TER, there are other costs to consider, including, but not limited to, brokerage commissions, bid-offer spreads, market impact and tracking error.

Q:        Does ETF liquidity matter?
A:         Yes. When it comes to sizing up ETFs, more liquidity (at the level of both the ETFs shares as well as its underlying securities) is better. This is because liquidity tends to be negatively correlated with transaction costs.

            When referring to ETF liquidity, most investors tend to refer to the amount of “on-screen” trading that takes place on a given exchange. “On screen” liquidity refers to the public quotes and subsequent trade data that are centrally collected, published and widely disseminated by most major exchanges. These metrics are particularly popular amongst retail investors.

            It is vital to note that there are market makers for ETFs who provide liquidity for investors on the exchanges. Though it is fair to say that it would be easier to gauge an investor’s potential ability to execute a trade by looking at “on-screen” liquidity, larger investors are also be able to directly engage the help of market makers to execute their (typically larger) trades.

Q:        Should I hedge my RMB exposure? And if so, how?
A:         It depends. This answer to this question ultimately depends on the investor’s view on the currency and the amount of risk that they are willing to take. For investors with a positive view on the RMB, hedging their RMB exposure will be counterproductive.

            The Chinese Equity ETFs currently available in the marketplace are mostly unhedged. Investors wishing to hedge their RMB exposure could consider utilising derivatives such as the USD/CNH futures available through the HKEx. As a general note of caution, investors should understand how these instruments work before making any investment decisions.

Jackie Choy, CFA, is an ETF Strategistwith Morningstar.