Trading two Chinas

March 23, 2017 10:00 AM

Even the most inobservant investors can spot the arrival of the Chinese New Year by the ubiquitous column in every financial journal declaring that “20XX Belongs to China” and telling you that you need to add exposure to the world’s “largest untapped market.”  

Why you need to buy tends to shift from one year to the next; maybe it’s because MSCI will finally add mainland Chinese stocks to their EM index, or that debt-to-GDP is stabilizing but from our standpoint; the “why” doesn’t really matter nearly as much as the “how.” ETFs give investors an easy and affordable way to invest in overseas markets, but don’t assume that because two funds are interchangeable just because both have China in their names.  

The first step in picking a good China fund is remembering that Chinese equity markets remain highly fragmented and localized beyond anything you’d find in the West. What firms come to mind when you think about China? Alibaba (BABA), Baidu (BIDU) or JD.com (JD) are just a few of the most common names, and even though you can buy them via American Deposit Receipts (ADR) in the United States, you’re in for a shocker if you think they’re core holdings of every China fund.   

Historically, China strictly limited access to their domestic, yuan-denominated stock market (A-shares) with most international investors forced to invest in China through Chinese companies that choose to register in Hong Kong where they were known as H-shares.  Authorities made the bulk of their domestic stock listings available to outside investors in late 2014, but several structural factors persist leaving a firm division between the two markets to this day. We’re currently tracking 30 China-oriented equity ETFs and the bulk of investor assets remains in the older H-share funds leaving the smaller A-share funds with all the problems common to smaller funds, namely low liquidity, high bid-ask spreads and extreme volatility.  

Low fees and high liquidity might make those H-share funds seem like an easy decision, but first compare one of the largest China funds, the iShares MSCI China ETF (MCHI) and its close cousin the iShares MSCI China A ETF (CNYA). Enough companies have chosen to list themselves in both markets to ensure a certain degree of overlap, but getting beyond the one-page factsheets will show you two very different funds.

CNYA, with a mere $10 million in assets and currently more than 420 names in its portfolio (nearly three times as many holdings as MCHI) helps explain why the fund has a much smaller feel to it with the fund’s average market capitalization at around $13 billion versus $53 billion for MCHI. Both funds have roughly similar allocations to financial names, around 25% to 27% or their portfolios. But having stocks like Baidu or Alibaba in the mix gives MCHI a heavier technology and consumer focus while CNYA has an almost old-China feel with a focus on more industrial and energy-related names. Think less Internet retailing and more coal mining.  

If you’re thinking there’s an arbitrage opportunity thanks to all the government regulation, check out the Hang Seng China AH Premium Index which tracks the price differences among the largest companies that trade in both the A- and H-share markets. The most recent reading was over 120, indicating that A-shares were trading at a 20% premium to their H-share counterparts and down from a peak reading of more than 150 back in July 2015. Within the index, financials and bank stocks tend to be more fairly priced, while smaller cap energy and industrial A-share names are trading at a more extreme premium to the H-share class leaving traders to make up their own minds on which China to put their capital to work in, in 2017.

About the Author

Matt Litchfield is content editor for ETF Global (ETFG.com) and is responsible for all posts and new product updates on ETFG.com. @ETF_Global