How China's stock crash affects ETF investors

Can I sell my ETF if it can't trade its assets?

By the middle of last week more than 50 per cent of all listed companies on China's two main exchanges had halted trading and the market had lost 12 per cent in a single week. Shares are automatically suspended from trading in China if they lose more than 10 per cent in a day and over 700 companies had also filed to suspend their shares from trading to prevent further losses.

Many of those shares are tracked by ETFs. On Wednesday 80 stocks within the CSI 300 index (tracked by db x-trackers Harvest CSI 300 Index UCITs ETF (DR)) were suspended and even the A50 index, which tracks the largest and most liquid Chinese stocks had four stock suspensions.

If you are an investor used to open-ended fund structures, the thought of a fund not being able to trade its underlying assets will strike fear into your heart. But don't panic. The structure of ETFs means that even when the underlying assets are taken out of the market, the ETF can still be bought or sold and you can still get out of the investment. Your ETF provider does not need to sell the underlying assets in the ETF just to pay you back.

Because ETFs trade on the stock market there is usually a buyer to match up with any investor wanting to sell. Even as investors pile out of ETFs, market participants such as market makers will almost always offer a price for an ETF even if no retail investor wants to buy them. Even though ETFs are struggling with poor primary market liquidity – unable to deal in their underlying holdings - providers say secondary market liquidity remains strong.

However others say the viability of ETFs could be threatened if the situation worsens and market makers become unable or unwilling to cut deals. Curtis Tai, vice president and vice president and ETF specialist at CSOP Asset Management, says: "Most market makers should be buying at heavy discounts but in the worst-case scenario investors might not be able to sell and then there's a risk that they would not be able to get their money back when they wanted it." However, he says that many providers prevent this problem by holding a cash buffer and paying investors from that reserve if they want to redeem the fund without a seller present in the market.

Why share suspensions should worry you

But share suspensions are an issue when it comes to the value of your China ETF, due to the difficulty of valuing what the ETF holds. If shares continually fall more than 10 per cent in a day, the stocks could be out of the market for several days at a time, during which the net asset value (NAV) of the ETF could drift far below the share price or correct very suddenly when the stocks resume trading.

Adam Laird, passive investment manager at Hargreaves Lansdown, says: "What we've seen is that when stocks are de-listed no one really knows the price so the market takes an average of what it expects them to be worth."

Mr Tai says: "We've seen a lot of ETFs starting to trade at massive discounts to NAV.

"ETFs tracking large-cap stocks have smaller discounts while smaller-cap stocks have lower liquidity and tend to be suspended more from the market and ETFs tracking those are trading at higher discounts of as much as 15 per cent."

Even synthetic China ETFs, which do not buy the basket of physical assets, are trading at large discounts. The db x-trackers CSI 300 Index ETC (XCHA) has reached almost -10 per cent and the other main China ETFs available on the London stock exchange are also trading at far higher discounts than their average, according to Mr Laird.

Nitesh Shah, analyst at ETF Securities, says: "When it gets to the point where there are a significant number of stocks not available then pricing becomes difficult."

However, David Liddell, ceo at Ipso Facto Investor, says that large cap ETFs have so far not suffered too much. "The larger market cap constituents should still be trading so the MSCI and FTSE indices at least should be relatively unaffected," he says.

What does it all mean for you? As a seller, it means you could be selling at the worst time and if you are holding on, you could see very sudden corrections to NAV and share price as stocks fall in and out of the market.

Big losses

Among all of the concerns for investors in China today though, the main question is how much you stand to lose in the current market rout. The Shanghai Composite index has fallen by more than 30 per cent since mid-June and on 8 July dropped by as much as 8.2 per cent, leading analysts to dub it 'Black Wednesday'.

Since the beginning of June, China ETFs have lost around 30 per cent each, reversing the gains they made earlier in the year.

Nitesh Shah, associate research director at ETF Securities, argues that this is an expected market correction. He says: "The MSCI China A share has fallen approx 30 per cent over the past three weeks but you have to put that into context in the growth of that index over the past year which has gone up by just over 140 per cent to its last peak. There was a very rapid growth in that index and it is something which we would associate with a lot of volatility. You are likely to see corrections."

Other strategists argue that the Chinese stock market should worry investors even more than the ongoing debt crisis in Greece. This is because the Chinese stock market losing a third of its value is equivalent to the UK's entire economic output last year.

Mr Laird says: "For existing investors, we'd urge holding tight. Selling in times of stress is rarely ideal - prices are volatile and investors could receive a worse price than if they wait. Even after the strong rises, China didn't appear overvalued on many of our valuation metrics. These falls could be a buying opportunity for investors willing to hold for the long run.

"Once things settle down, it's wise for investors to review their choices. China is a volatile emerging market – you should only hold this if you can tolerate the risk."

Performance (total return %) of China ETFs

Source: FE Trustnet, as at 9 July 2015

The growing discounts of China ETFs

Source: Bloomberg, Hargreaves Lansdown as at 9 July 2015