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ETFs offer a direct route to China but watch the tracking

ETFs offer the most direct route to Chinese equities, but many are failing to closely track their benchmark
February 2, 2017

The number of exchange traded funds (ETFs) offering access to China's formerly restricted domestic market, or A-shares, is growing. A-share indices feature a range of large and exciting Chinese companies, but are highly volatile due to frequent stock suspensions and restrictions on foreign share ownership. And this is causing tracking issues for the ETFs that follow them.

The MSCI China A, MSCI China A IMI, CSI 300 and FTSE A50 indices, which are made up of renminbi-denominated onshore stocks, have been on a rollercoaster ride. Over the long term, the best-performing indices have been those with the largest number of constituents, such as MSCI China A index. But in the short term the benchmarks that focus on stock liquidity and size have outperformed.

Over 10 years the best performing domestic, renminbi-denominated A-share index has been MSCI China A, which returned 174.8 per cent in sterling, compared with 106.8 per cent for FTSE China A50 index.

 

MSCI China A index sector weightings

Sector%
Financials 23.94
Industrials 18.52
Consumer discretionary 11.85
Materials 10.62
IT 9.8

Source: MSCI

 

Over five years, however, the newer MSCI China A IMI index is the best performer of the four A-share indices, returning over 100 per cent compared with 73.7 per cent for MSCI China. This index is designed to track shares with a wider range of market caps, but no London-listed ETFs track it.

MSCI China A IMI is by far the largest index in terms of number of constituents, with 2,070. MSCI China A has 861 constituents from the Shanghai and Shenzhen exchanges, while CSI 300 - the first index to bring together both these stock exchanges - is less diversified, with 300 stocks. However CSI 300 includes the largest and most liquid A-shares so has been popular with investors.

Over one year, CSI 300 index has returned 28.1 per cent. But, like the broadest indices, it has been volatile due to its weighting to Shenzhen-listed stocks, which tend to be younger and more technology-focused businesses than those listed in Shanghai. Financials account for a large chunk of the CSI 300 as well - more than 40 per cent.

 

CSI 300 index sector weightings

Sector%
Financials 40.6
Industrials 16.4
Consumer discretionary 11.2
IT 8.6
Consumer staples 5.9

Source: CSI

 

The least volatile A-share index is FTSE A50, which is made up of 50 of the largest and most liquid blue-chip Chinese stocks.

 

FTSE China A50 index sector weightings

Sector%
Banks41.78
Insurance 12.74
Financial Services11.89
Food & Beverage6.62
Industrial Goods and services 6.45

Source: FTSE Russell

 

"FTSE A50 is effectively the blue-chip index of Chinese A-shares," says Chris Mellor, executive director at ETF provider Source. "It includes the largest 50 stocks listed on the mainland, and the vast majority of those are listed in Shanghai, with three or four listed in Shenzhen. The CSI 300 has a greater proportion of stocks listed on the Shenzhen exchange than FTSE A50, which means it is a higher-beta index. It includes some of the most exciting companies in China, but is also higher risk."

CSI 300 index fared worse than FTSE A50 during the major stock market rout that hit China in January 2016, but MSCI China A and MSCI China IMI lost more over the month. Both shed more than 20 per cent compared with a loss of 17.7 per cent for CSI 300 and 12.8 per cent for FTSE A50.

A major feature of the market rout in January 2016 was the raft of stock suspensions, halting a swath of shares that had suffered losses from trading. Stock suspensions are a controversial feature of the Chinese stock market, and have been a sticking point for index providers such as FTSE and MSCI who have so far refused to add Chinese A-shares to broader emerging market indices.

 

The tracking problem with A-share ETFs

As well as making the Chinese market volatile for investors, stock suspensions affect the ability of ETFs to track their benchmarks effectively.

ETFs following CSI 300 index have delivered the worst tracking difference over recent years. Over three years, db x-trackers CSI300 UCITS ETF (XCHA), the first ETF to track A-shares and a synthetically replicating fund, returned 72.7 per cent compared with 89.6 per cent for CSI 300 index.

Lyxor UCITS ETF CSI 300 A-Share (CSIA) returned 74.4 per cent and db x-trackers Harvest CSI300 Index UCITS ETF (ASHR) returned 84 per cent.

Physical ETFs have a better tracking record due to their lower costs, but there are other problems that make the Chinese market hard to track. ETFs frequently hold stocks that may be suspended from trading and may drop out of the index altogether at a later point. When that happens, there is often a mismatch between the value ascribed to that stock by the index provider and the real value the fund sells at when the stock resumes trading again. "The major quirk with Chinese ETFs when it comes to tracking and performance is around stock suspensions," says Dr Mellor.

The performance difference between an ETF and an index is particularly marked if a suspended stock is removed from an index. In this circumstance, the index provider and ETF manager both estimate a fair value assumption for the suspended stock before removing it from the index. However, if the stock is still halted from trading at the time of the expulsion, the ETF has to wait before it can sell it to reflect the new composition of the index. And when the stock resumes trading it is likely to be at a higher or lower value than was assumed at the time of its expulsion from the index, so the return of the ETF will diverge from the index it tracks.

This happened in 2015 when China Yangtze Power (600900:SHH) was suspended from trading on 13 June and ejected from the FTSE A50 in September 2015. The stock resumed trading on the Shanghai Exchange on 17 November 2015, at which point ETF providers were able to sell any remaining shares into the market.

CSOP Source FTSE China A50 UCITS ETF (CHNP) held this stock. In a notice to the market on 17 November 2015 it said the higher than expected price of the remaining shares sold meant the fund was "expected to outperform the index by approximately 1.64 per cent" on the day of the sale.

Tight offshore investment quotas, currency costs and the Chinese markets being open at a different time to the London Stock Exchange add to the difficulties of trying to replicate the returns of China A-share indices.

James McManus, analyst at wealth manager Nutmeg, says: "The underlying Chinese equity market is not open when China A-shares ETFs are trading in London, meaning that these ETFs act as price discovery vehicles for the A-share market and reflect changes in sentiment and newsflow. That means the prices of the London ETFs can potentially move away from the previous closing price of the underlying shares in China."

On top of that, China A-share ETFs also suffer wide discounts to net asset value (NAV) during times of stress as they continue to trade even as the stocks within them are halted. That means they are used by traders to take tactical positions, resulting in volatile prices relative to their underlying holdings.

The A-share market, made up of domestic Chinese-listed shares quoted in renminbi, has been highly restricted to overseas investors. But the Shanghai-Hong Kong Stock Connect programme has enabled overseas investors to access it in recent years, giving them access to some of China's largest stocks. And last year the Hong Kong-Shenzhen Stock Connect was launched, allowing foreign investors to access the high-growth technology businesses listed on China's other major stock exchange.

However A-shares remain in limbo when it comes to inclusion in broader emerging market indices. MSCI denied China's domestic markets inclusion in international benchmarks for a third year in a row in June last year citing issues surrounding market liberalisation.

 

The mix-and-match China A-share ETFs

Investors and wealth managers have long been calling for a China equity ETF that spans the range of available Chinese share types, including Hong-Kong listed H-shares as well as domestic A-shares.

Last year WisdomTree became the first provider to launch a China ETF offering access to the full range of Chinese share classes, including those listed onshore and overseas. ICBC Credit Suisse WisdomTree S&P China 500 UCITS ETF (CHIP) is the first ETF to combine all China equity share classes.

It has 38.7 per cent of its assets listed in Shanghai, 34.6 per cent in Hong Kong, 16.6 per cent in Shenzhen, and the remainder in New York and Singapore. Over six months it has returned 10.9 per cent, with an ongoing charge of 0.75 per cent.

db x-trackers Harvest FTSE China A-H 50 Index UCITS ETF (AH50) also launched in 2016, which attempts to overcome the price premium of A-share stocks by buying the same company via its A-share listing when it's cheaper than its H-share listing.

It has outperformed the WisdomTree fund over six months, with a return of 15 per cent. It is a far more concentrated fund with just 50 holdings, and highly concentrated in one sector - almost 60 per cent of its assets are financials stocks.

When choosing an A-share ETF, look at its concentration, number of holdings and track record. This is also an area where a physical ETF might be better, as the higher cost of a synthetic ETF is an additional drag on performance.

"Should we wish to invest in A-shares we would want to do so through an index that provides access to large-cap and liquid stocks, and isn't too heavily concentrated," says Mr McManus. The CSI 300 index aims to provide access to the 300 stocks with the largest market capitalisation and liquidity from the entire universe of listed A-share companies. Deutsche Bank Asset Management offers a physical product that tracks this index with a management fee of 0.65 per cent a year. However, investors considering A-shares ETFs should be cognisant of the performance and price volatility the products have historically shown."

 

A-share indices and ETFs tracking them (cumulative share price returns)

Index/ETF*Ongoing charge (%)**Physical/synthetic1m (%)3m (%)6m (%)1yr (%)3yr (%)5yr (%)10yr (%)
FTSE China A50 index3.0-0.212.329.596.374.4106.8
CSOP Source FTSE China A50 (CHNP)1.15Physical4.91.512.332.696.0
CSI300 index 1.5-3.58.226.889.676.3
db x-trackers Harvest CSI 300 UCITS ETF (ASHR)0.65Physical0.4-3.96.528.984.0
db x-trackers CSI300 UCITS ETF (XCHA) 0.5Synthetic1.3-4.16.823.372.7
Lyxor UCITS ETF CSI 300 A-Share (CSIA)0.4Synthetic2.8-2.88.026.974.4
MSCI China A index1.0-4.86.424.979.373.7174.8
Lyxor Fortune SG ETF MSCI China A (CNAL) 0.85Direct2.1-3.86.530.5
ETFS-E Fund MSCI China A GO ETF (CASE)0.94Physical1.2-4.86.123.6
iShares MSCI China A (CNYA)0.65Synthetic1.3-4.06.726.4

Source: FE Trustnet, *Morningstar, **provider websites

 

Newer A-share ETFs (share price returns)

*Ongoing charge (%)**Physical/synthetic1m (%)3m (%)6m (%)
db X-trackers Harvest FTSE China A-H 50 (AH50)0.65Direct2.9-0.515.0
ICBCCS WisdomTree S&P China 50 UCITS ETF (CHIP)0.75Physical3.3-2.410.9

Source: FE Trustnet *Morningstar **Provider websites