Synthetic China A-Shares ETFs earn up to double-digit outperformance from ‘structural anomaly’

Alpha on synthetic A-Shares ETFs has reached as high as 16% in the last four years

Jamie Gordon

a city skyline at night

Two China ETFs from Invesco have quickly become an integral part of the offshore lending market for China A-Shares and are earning investors significant excess returns as a result.

Launching on 5 May, the $119m Invesco S&P China A MidCap 500 Swap UCITS ETF (C500) and $113m Invesco S&P China 300 Swap UCITS ETF (C300) currently carry swap fees of -8.40% and -2.90%, respectively.

In practice, this means investors are actually earning the return of the underlying A-Shares exposure plus additional performance of 8.05% and 2.55%, after the ETFs’ total expense ratios (TERs) of 0.35% are factored in.

According to Christopher Mellor, head of EMEA ETF equity and commodity product management at Invesco, this under-the-radar alpha is happening because of an “interesting structural anomaly” in China A-Shares.

“The A-Shares market is extremely liquid with high retail participation, which makes for a pretty attractive environment for quant hedge funds to run long-short market neutral strategies,” Mellor told ETF Stream.

“The problem is it is very difficult for those hedge funds to short the market. The reason for that is there is no physical securities lending market for offshore investors into the onshore A-Shares market.”

Equally, it is difficult to access futures contracts on A-Shares so hedge funds looking to short the market are having to use an index portfolio approach through swaps.

In practice, this means hedge funds approach a swap counterparty and agree they will receive the performance of a benchmark in exchange for a fee.

The counterparty bank then must create a way of hedging their exposure themselves. Given the difficulties of going short on the A-Shares market and borrowing, banks charge “an awful lot” for these counterparty services, Mellor said.

He added: “In terms of the ETF, it provides a good vehicle for the banks to offset that exposure they have taken with the hedge fund and they do that by offering to pay the performance of the S&P A-Shares MidCap 500 through to the ETF and in return, the ETF paying through the performance of the swap basket.

“What we end up with is the ETFs benefitting significantly from the high fees that banks are able to charge hedge funds.”

He noted while C500’s swap fee currently stands at 8.4%, it can vary significantly based on hedge fund demand, market conditions and the status of China A-Shares lending by offshore investors.

Over the last four years, the lowest level of outperformance seen on the S&P China A MidCap 500 index has been 4% but it has touched as high as 16%.

Western investors are becoming increasingly aware and interested in Chinese domestic listings as a means of diversification from their own domestic equities and also more well-known Sino companies. 

This accelerated with the arrival of the Shanghai Stock Connect scheme eight years ago and sped up further in 2019 as quotas were removed from the Qualified Foreign Institutional Investor (QFII) programme and MSCI began adding A-Shares to its emerging market benchmarks.

As China remains one of only two major economies in modestly positive ‘real rates’ territory – and US equities are in a bear market – Invesco’s synthetic A-Shares ETFs may represent tools for diversification with some unique structural twists.

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