China in your hand

by , 15th October 2018

China has hit the headlines in recent weeks amid Trump’s trade wars, allegations around its Interpol chief taking bribes, and falling markets on the back of the People’s Bank of China announcing it would cut the amount of cash the country’s lenders are required to hold as reserves.

However, it also made headlines earlier this year when the first smart beta China A shares ETF hit the European market after Market Access launched its China A minimum variance ETF.

The ETF tracks the Stoxx China A 900 Minimum Variance Unconstrained AM index that selects and weights stocks listed on the Shanghai and Shenzhen stock exchanges based on their volatility and how heavily traded they are. It costs 0.65% and since its launch on June 8 it has returned -2.4%, according to Bloomberg data.

Some market watchers have described it as niche and questioned why investors wouldn’t want a global approach. It’s fair comment. After all assets in the ETF are not even at $1m and China A Shares have performed poorly in the last year. But this concept of smart beta and markets like China A shares (yuan-denominated Chinese stocks) is worth discussing.

First, China A Shares only made it into the MSCI Emerging Index this year despite being the second largest economy in the world and on MSCI’s review list since 2013; suggesting there is more to come. It was previously rejected due to corporate governance issues, capital mobility restrictions and tax issues. China has since been working on reforming its capital markets.

Second, the China A shares market has returned 52% over the last five years, although this year has been disappointing with a fall of -6.4% since January. But there is hope. The MSCI announcement is expected to prompt an uptick in foreign inflows into China’s domestic markets – a Reuters article comments that “some funds tracking the MSCI A-share inclusion index have seen heavy inflows since announcement of the China entry”.

Third, smart beta is really gaining traction. According to ETFGI, assets in smart beta ETFs and ETPs globally reached a record $680bn at the end of August. August marked the thirty-first consecutive month of net inflows. There are now 1,240 smart beta ETFs globally from 151 providers.

Smart beta is no magic wand, but it can offer investors specific solutions when accessing markets that can often be improved with a level of filtering. In the case of China A Shares, it’s filtering out certain companies that you might not want exposure to. For example, quality dividend indexes typically screen dividend-paying companies for quality. They pick the more profitable on the basis that they typically have less volatility and better returns over the long term.

In the case of China this could be a good thing. For example, China still ranks only seventy-seventh on the corruption perceptions scale from Berlin-based non-profit Transparency International’s 180-country corruption perceptions scale. The perceived level of public sector corruption is also low at 44, on a scale of 0-100.

Similarly, the world bank’s world governance indicators put China in middle for regulatory quality. It scores between 30 and 50, better scores are around 90. Despite this, its control of corruption is improving as is its Rule of Law.

However, in Europe there is still only one ETF

The most likely reason for this is access. The China A shares market has been notoriously difficult to invest in and it is still not fully open to foreign investors. Those wanting access can go through the QFII (qualified foreign institutional investor scheme), which allows certain companies to directly invest in Chinese stocks. Another way is through the RMBQFII scheme, which allows the use of renminbi to invest in Chinese stocks – and essentially makes use of the Shanghai and Shenzhen exchanges connection. The daily quota of Chinese mainland purchases is around ¥52bn.

In the US there are a handful of china smart beta ETFs, such as KraneShares Zacks New China ETF (KFYP), which tracks the Zacks New China Index. The multi-factor ETF tracks companies listed in the index, which measures the performance of publicly traded, China-based companies operating in targeted industries of China’s 13th Five-Year Plan

Similarly, the First Trust China AlphaDEX Fund (FCA) was incorporated in 2011 and has nearly $9m in assets. Despite a poor run this year it has a returned of 9.27% over the last three years, according to Bloomberg. It tracks the investment results that correspond generally to the price and yield of an equity index called the NASDAQ AlphaDEX China Index.

Other smart beta China focused ETFs in the US are the KraneShares MSCI China Environment index ETF (KGRN); the CSOP MSCI China A International Hedged ETF, which tracks the MSCI China A International with CNH 100% Hedged to USD Index; And the Reality Shares Nasdaq Nexgen Economy China ETF (BCNA), a crypto and blockchain focused ETF, launched in June this year.

Market Access’ ETF offering is interesting and, in my view, comes at a fairly good time. This concept of smart beta on big, growing emerging economies is worth exploring. As Danny Dolan, MD of China Post Global in the UK said in June: “China has for some time been the primary engine of global growth and there is significant investor demand for China exposure, though in many cases allocations are being held back by concerns about higher volatility.”