China in perspective

The government crackdown on certain types of companies in China has made many investors nervous

China flags in a row

Last year was tough for China equity ETFs amid regulatory crackdowns, strained US relations and concerns regarding human rights and foreign policy. Still, the country remains a massive market with a range of growth prospects. So how can investors navigate this complex environment?

Most of the 10 largest US-listed China equity ETFs were down anywhere from almost 4% to more than 40%, as at 30 November 2021, with even the nearly $5bn iShares China Large-Cap ETF (FXI) down 13%. However, there were some relative bright spots, such as the US-listed VanEck ChinaAMC SME-ChiNext ETF (CNXT), up more than 11% year-to-date.

Meanwhile, the iShares MSCI China A UCITS ETF (CNYA) was up more than 2%, and the KraneShares Bosera MSCI China A Share ETF (KBA) was up almost 2%. Funds focused on China A-Shares are less dependent on the consumer discretionary sector which has been under pressure, Todd Rosenbluth, head of ETF and mutual fund research at CFRA, explained.

Many investment analysts are growing warier of the giant market. Rosenbluth sees “the risk being elevated given the increased volatility”, Many investors are already getting hefty exposure to China via broader emerging market or regionally focused ETFs, he said, which may be enough for now.

“We would not be overweighting,” he noted. “We would certainly look to find other areas in which to invest in emerging markets.”

Rosenbluth highlighted India and Taiwan, both of which are “better positioned, with fewer regulatory risks and thus more upside potential, in our opinion.”

Complicated scenario

But it is a complex picture, according to Ben Johnson, director of global ETF research for Morningstar. The largest China-focused equity fund by AUM is the KraneShares CSI China Internet ETF (KWEB), with assets of approximately $8.9bn and negative returns year-to-date of just over 42%. However, KWEB attracted large inflows in 2021. While “at face value, that seems somewhat counterintuitive,” Johnson said, it suggests US investors still see potential in the Chinese internet domain.

KraneShares specialises in the Chinese market. Its CIO Brendan Ahern argued it is a mistake to view China “as a singular entity”. For example, regulatory actions are being pursued by different regulators moving at different speeds, he said. That can feel somewhat ad hoc to outsiders, he noted, sometimes pushing them to the sidelines because they do not understand what is happening. However, at least when it comes to the internet sector, Ahern feels “we might even be done with this regulatory cycle…there are green shoots that indicate the worst is likely behind us”.

For example, Ahern pointed to a recent speech by Vice Premier Liu He in which the senior official highlighted the importance of the private economy which he said accounts for 50% of tax revenue, 60% of GDP and 80% of urban employment. “We believe this was really messaging,” Ahern said.

State Street Global Advisors (SSGA) runs the SPDR S&P China ETF (GXC), a $1.6bn fund that is down just over 17% year-to-date. Matt Bartolini, head of SPDR Americas Research at SSGA, said Chinese stocks have faced a range of headwinds. Additionally, the country’s growth expectations, while still above those of the US, are lower than in the previous years, he noted.

Still, exposure to China is hard to avoid, Bartolini suggested, and “definitely warrants consideration, even as part of a broader EM strategy.” The country’s GDP is about six times bigger than that of India, the next-largest EM economy. “Just because of the sheer size alone, it continues to warrant an allocation, in some cases a stand-alone allocation,” he said.

Multifaceted market

Despite all the concerns, “investors are helped by the fact that it is such a large market,” noted William Sokol, product manager for ETFs at VanEck, which operates funds like CNXT.

“You can be selective,” he said. “You can slice and dice the opportunity set.” For example, investors could focus on sectors according to the perceived regulatory risk, or look more to balance sheet fundamentals.

The EMQQ Emerging Markets Internet & Ecommerce UCITS ETF (EMQQ) – a $280m ETF that is down about 27% year-to-date – offers exposure to the growing internet and eCommerce sectors in emerging markets. EMQQ is naturally dominated by Chinese companies which comprises 61% of holdings by weighting.

In January, the team behind EMQQ launched the FMQQ Next Frontier Internet & Ecommerce UCITS ETF (FMQQ), which focuses on similar themes but excludes China. However, EMQQ and FMQQ founder Kevin Carter insists the new launch does not stem from concerns about China, but simply provides access to “a different sort of opportunity set,” focused on markets at a much earlier stage of development.

Indeed, Carter argued many of the fears about China are unfounded, noting other countries are also increasingly focused on regulating their internet sectors, for example. 

“They understand capitalism, they have benefitted from it more than anybody,” Carter explained. “They are unlikely to move away from capitalism in spite of what the headlines might have you think.”

Excluding China

Other funds look beyond the Chinese market and see potential financial benefits to that approach. Perth Tolle is founder of Life & Liberty Indexes, which built the index behind the Freedom 100 Emerging Market ETF (FRDM), an ETF that invests in companies with high scores for personal, political and economic freedom. That means China is excluded.

FRDM was launched in May 2019, so had its first full year during COVID-19. “Our thesis that freer markets recover faster played out,” explained Tolle. “The assets came in faster after that, but they really accelerated in 2021, after the Chinese government’s actions against their tech, education, and real estate sectors.” The ETF’s assets have more than doubled in the second half of 2021 sitting at about $105m today. It has seen returns of just under 3% this year.

“Investors can better capture growth in the stock markets of freer countries, due to rule of law and private property rights, including shareholder rights,” she argued. “The freer EMs are where we’ll find and capture the growth stories of the next decade.”

Arne Noack is head of systematic investment solutions, Americas at DWS Group, which operates the Xtrackers Harvest CSI 300 China A-Shares UCITS ETF (ASHR), a $624m ETF that is down almost 4% year-to-date. For those interested in longer-term investments, he posited that “the China equity market is something to always consider”.

While he recognises the concerns regarding geopolitical and economic risks, Noack stressed the need for investors to attempt a careful balance: “Consider it with some caution but do not dismiss it outright. In dismissing it outright, you are likely to forgo significant opportunities in the long run.”

Finding a balance

In the grand scheme of things, China ETFs are a fraction of the overall universe of US-listed ETFs, Morningstar’s Johnson said. ETFs belonging to Morningstar’s China region category held a combined $38bn assets as at the end of October, compared with just over $7trn in US-domiciled exchange-traded products.

Most investors likely gain their China exposure through a more diversified portfolio, such as an emerging markets ETF. The majority also continue to favour their home markets, whether they are based in the US or any other country, Johnson said, adding that, in most cases, they will likely be best served through an allocation to emerging markets at large.

“For many investors, what is going on in Chinese stocks on any given day or week or month or year probably is not keeping them up at night.”

This story was originally published

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