China ETFs have always been a bit of a puzzle. On the one hand, everyone agrees that long-term China is a buy. Yet on the other hand, investors have mostly ignored China, preferring emerging markets or Asia ETFs instead. But index changes could soon force a change of habit, iShares believes. We spoke to Thomas Taw, head of APAC iShares investment strategy at BlackRock’s Hong Kong office, to find out more.
ETF Stream: Investors are often perplexed by China’s many different share classes. Whereas most country’s just have ordinary shares, China has A, B, S, N and H-shares, then there’s P chips, Red chips and ADRs. What are the differences between them and what do investors need to know?
Thomas Taw: We call it the alphabet soup exposure, and yes – it can be quite confusing.
For us, the distinction that matters is onshore versus offshore. Simply put, onshore refers to stocks that are incorporated in Mainland China, whereas companies listed elsewhere, i.e. Hong Kong or Singapore, but derive most of their revenue from Mainland China, are referred to as offshore.
A-Shares are the most significant for China’s domestic economy as they give investors direct access to China’s onshore equities. The A-Shares market is the largest by market cap and equates to roughly US$7.5 trillion. The second most significant are probably H-shares. These are Chinese companies that are traded on the Hong Kong Stock Exchange. The H-shares market is worth roughly $760 billion, and tilts more towards growth and technology stocks.
So the best way to invest in China is just to buy A-Shares, I take it? That way you can also be co-invested with Chinese people?
If you’re looking for pure China domestic exposure then yes – A-Shares are the way to go. A-Shares tend to be more focussed on what gets labelled “old economy”, consisting largely of financials and industrials.
To buy A-Shares you need a Renminbi Qualified Foreign Institutional Investor (RQFII) license. These can be hard to get and can have quotas, as I understand?
QFII / RQFII is not as relevant these days.
As China’s capital markets have opened up, so has the accessibility of Chinese equities for foreign investors. With the introduction of the stock connect program in 2014, the game changed. The max quota on QFII/RQFII has recently been scrapped and investors can gain access to onshore China through Hong Kong. It’s far simpler now - even retail investors can buy Chinese equities on stock connect.
What’s the Chinese government’s attitude to foreigners trading A-Shares?
Naturally they welcome it. The aim is to further open up capital markets and bring in more foreign capital, although a few hurdles remain.
Within Mainland China, pension funds and mutual funds are growing. Many of these domestic institutions will look for returns onshore by buying domestic Chinese equities. The market will also be more reliant on foreign inflows as time goes by, that’s generally the norm for an emerging market.
A lot of foreign investors worry about investing in China’s state owned enterprises (SOE), which they worry will favour government policy over shareholders. Do these fears have any basis?
In our experience, the main concern of investors hasn’t so much been the Chinese government setting policy or growth targets. Investors’ main concern with SOEs has been their volatility and inefficiency.
On the flip side, however, industries with many SOEs tend to have a low correlation to global equities. This low correlation is a byproduct of state ownership as they are long term owners that won’t sell their stake because of a pickup in volatility or a market sell off.
Index providers have said they’re going to give A-Shares more room in their indexes. What will this look like and why does it matter?
In 2019, MSCI quadrupled China A-Shares weighting in its emerging markets and other indexes. As of the end of November 2019, China A-Shares represent about 4% of the MSCI Emerging Markets Index, with offshore Chinese shares at approximately 29% of the index.
Why does this matter? Because there is roughly US$1.8 trillion tracking MSCI EM. Passive and active funds that track this index need to increase their exposure to Chinese A-Shares or risk tracking error. This leads to billions of dollars in institutional flow into China. As time goes on, and if the inclusion factor increases further, it will fundamentally change the dynamic of how Chinese equities are traded and valued.
At the moment Chinese retail investors account for roughly 80% of trading turnover for A-Shares. Foreign ownership of China A-Shares is still only around 3%.
Will Chinese stocks rise as a result of these index changes? If I were to buy A-Shares before they get included in these indexes, could I front run the index rebalances?
I’ll answer that second question first: no – we don’t talk about index inclusion as an arbitrage opportunity. In terms of the anticipated flow, as much as $40 billion could enter A-Shares as a result of the latest index changes. This figure assumes that active funds increase their weighting to A-Shares to neutral, which is unlikely, but it’s still an impressive figure. Whilst this may seem like an arb opportunity, the A-Shares market can trade up to $90bn of turnover in a day.
Nonetheless, we have seen some effects on performance: when index providers make unexpected announcements about stock inclusions or exclusions, volatility tends to ensue.
We also anticipate that any further increase in A-Shares inclusion will affect performance over the long term. Historically, Chinese retail investors have preferred small companies because of their higher beta. Foreign institutional investors, however, buy larger caps for tracking purposes and because of the higher liquidity.
As foreign institutional inflow increases, we’ll see the continuation of this shift, with increased inflow to large cap A-Shares.
Investors complain China ETFs are too expensive compared with broad emerging market ETFs or Hong Kong ETFs. Why are China ETFs more expensive?
ETF fees are typically determined by the accessibility of the underlying market.
The main costs with emerging markets like China are the cost of hedging the local currency and the relative lack of options and derivatives for foreign investors to hedge equity positions.
Other factors also play a part. For example, the fund’s inception date and whether clients are using the exposure for tactical or strategic purposes. Older China ETFs have tended to be more expensive as they have built up a strong liquidity over time and are used for tactical, short term use. In this case, the annualised expense ratio of the ETF is less relevant. Traders care less about annual management fees because they don’t hold it all year.
More recently listed ETFs with China exposure, by contrast, tend to be cheaper as they’re used for longer, strategic and core holdings.
What opportunities are you seeing in China?
If Chinese regulators can successfully tackle hurdles for foreign investors, it is likely that A-Shares weighting in indexes will continue to increase. This will bring a significant amount of flow into Chinese equities and would eventually lead to investors seeing China as a separate asset class to emerging markets.
If we get to a stage where China gets an “inclusion factor” of 100% - which is where Chinese securities would be fully included in benchmark provider indexes and weighted based on market cap - China could take up 40% of the emerging markets index. At this point investors would most likely buy China as a standalone asset class, much like they do with Japan vs Asia and the US vs developed markets.