BlackRock has changed the index tracking investment approach on its China bond ETF to a fully replicating strategy in a move to reduce the tracking error, ETF Stream can reveal.

The iShares China CNY Bond UCITS ETF (CNYB) has been one of the firm’s most successful launches over the past few years having gathered $6.8bn assets under management (AUM) since being brought to market in July 2019.

In a note to shareholders last December, BlackRock announced plans to change CNYB’s index investment strategy in order to track the performance of the underlying index, the Bloomberg Barclays China Treasury + Policy Bank index, more accurately.

Previously, CNYB used an optimising investment strategy which meant it was not required to hold every bond issuer in its underlying index or even hold securities of each issuer in proportion to the index.

However, this became an issue when regulatory constraints prevented CNYB from investing in similar holdings to the underlying index in order to track its performance.

With an optimised strategy, CNYB is only permitted to invest up to 10% of its net asset value in bonds issued by each China Policy Bank.

This became an issue when each of the China Policy Banks started to account for more than 10% of index. For example, China Development Banks rose to a 28.3% weighting while the Export Import Bank of China rose to 10.3% and the Agricultural Bank of China jumped to 15.3%.

Overall, this left CNYB exposed to 30% to these three China Policy Banks while the index had a 53.9% weighting, as at 1 December 2020.

The move to a replicating strategy enables CNYB to benefit from higher regulatory investment limits on these types of strategies.

As a result, CNYB will be permitted to invest up to 20% of its net asset value in bonds issued by each China Policy Bank which can rise as high as 35% for a single China Policy Bank if it is justified in certain market conditions.

For example, if a China Policy Bank holds a particularly dominant position in the underlying index, this rule enables CNYB to track the performance of its index more closely.

Next frontier for ETF issuers is China's bond market

In the shareholder note, BlackRock said CNYB will hold bond issues of all issuers in similar proportion to the weightings of the issuers in its underlying index.

When this is not possible, CNYB can invest in bond issues not in its benchmark index but in ones that have similar performance and matching risk profiles.

A spokesperson from BlackRock said in a statement: “Changing the replication strategy on CNYB from optimizing to full replication will result in better tracking and an improved risk and return profile versus the index.”

The shareholder note added the ETF will bear any transaction costs incurred.

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