No longer an ‘optional extra’: What’s in store for China equity ETFs?

Huge divergence in performance between Chinese stocks this year

Anna Fedorova

a bridge over a river with a city in the background

At the beginning of this year, China became the epicentre of what turned out to be the biggest health crisis of our generation, as the deadly coronavirus found its first victims in Wuhan. The government implemented a full lockdown to stop the spread, factories and businesses were shut and economic growth plummeted by a record 6.8% in Q1.

Yet the Chinese government was quick to counteract some of the devastating effects of the pandemic, including running an active virus tracking system, adopting a stringent testing policy, and conducting regular neighbourhood surveillance to stem the infection chain from expanding.

As a result, while the sickness spread across the world, China has been enjoying a V-shaped recovery. By the second quarter, China’s economy grew by 3.2%, driven mainly by primary industry, which saw output rise by 9% as most factories reopened in April. Domestic consumption has also remained strong, despite lockdown measures. By the end of 2020, China could be the only major Asian economy to register positive growth, according to International Monetary Fund (IMF) forecasts – even as global GDP is expected to contract by 4.9%.

China’s mainland indices have reflected this quick recovery, with the Shanghai Composite rallying 5.5% over the year to the end of September and outperforming other Asian markets, according to Refinitiv. The Shenzhen Component Index (SZI) even soared 24.8% over period, outperforming blue-chip stocks.

Xav Feng, head of Lipper Asia Pacific research at Refinitiv, said: “China’s continued support of its businesses has allowed them to face the challenges to overcome the crisis and avoid going into a technical recession. Therefore, there is still a good opportunity for European investors to gain exposure to Chinese equities via China ETFs.”

Lacklustre flows

Yet European investors, many of whom were already underinvested in China, were scared away from the region as the coronavirus began its spread.

Briegel Leitao, associate analyst for manager research, passive strategies, at Morningstar, said: “European ETF investors have been slow to build up their China allocation, and the rumours of mainland China being the centre of the pandemic combined with the infamous unreliability of the CCP’s external media and reporting certainly didn’t help garner confidence either.”

Morningstar’s data shows European-domiciled Chinese equity ETFs saw a drop in assets of around 13% of total AUM bringing outflows to similar levels as at the height of the US-China trade war in 2018.

And although Chinese stocks have remained resilient, fuelled by domestic themes such as e-commerce and online entertainment, flows have failed to come back in any meaningful way. Data from TrackInsight shows outflows from Chinese equity ETFs have continued unabated, despite an average return of nearly 17% from these funds during the first three quarters of the year.

But according to Adam Laird, principal at Ards Ventures, investors can no longer ignore China. While some investors may once have considered it to be an “optional extra” for their portfolio, “it has clearly become a staple for most investors”, he said.

“China has been one of the best performers of the year, unrivalled in emerging market countries. The country supports a lot of strong healthcare, technology and consumer stocks – with a lot of room for growth.”

Hong Kong or Shanghai?

However, investors looking to gain exposure to the Chinese recovery must be aware of the huge disparity in performance between Hong Kong and Shanghai-listed companies. While mainland stocks have been enjoying a post-pandemic boom, Hong Kong listed equities have suffered as a result of the recent political upheaval.

Highlighting this, the Amundi MSCI China UCITS ETF (CC1U), which offers exposure to the H-Shares market, has fallen 13.6% so far this year, as at 12 October, while the iShares MSCI China A UCITS ETF (CNYA) is up 28.1%.

Laird said investors must therefore check which index their chosen ETF tracks before investing: “China and Hong Kong have performed quite differently this year, with different economic drivers. A lot of ETFs have very similar names and very different holdings – do not be caught out.”

Unlike mainland China, Hong Kong has remained stuck in a recession, with the Hang Seng China Enterprises index sinking 12.5% year-to-date, and consequently most ETFs tracking this index have delivered negative performance over the period.

Feng said: “Investors should select China ETFs highly correlated to the mainland China market but avoid the Hong Kong market.”

While the A-Shares market has been the strongest performer Ruli Viljoen, head of manager selection at Morningstar Investment Management Europe, added that “most investors will not want to exclude the country’s biggest stocks and as such we would select the MSCI China index as our ETF choice”.

The $1.6bn Xtrackers MSCI China UCITS ETF (XCS6) is Morningstar’s top choice.

Buyers’ picks

Peter Sleep, senior portfolio manager at 7IM, agreed that when picking the right ETF for exposure to Chinese equities, the key is to select as broad an index as possible to reap the diversification benefits. His top choice is also the XCS6 since it counts more than 700 stocks in total.

This also has the advantage of getting you away from the very big state-owned enterprises which tend to be seen as less dynamic than the smaller privately run businesses,” Sleep continued. “It is important to understand that when you get further away from the biggest 50 stocks listed in Hong Kong you do tend to get a bit more volatility and potentially poorer corporate governance.”

Laird, meanwhile, also suggested looking at the iShares MSCI China UCITS ETF (ICHN), which charges a lower fee than the Xtrackers product (0.40% versus 0.65%). Another contender is the Franklin FTSE China UCITS ETF (FLXC), which beats the other two at 0.19%, but Laird warns this product remains small at $35m.

However, Ben-Seager Scott, head of multi-asset funds at Tilney Group, argued selecting an ETF investing in the A-Shares market could also be a good choice for investors trying to avoid China’s SOEs.

“Many of the traditional market-cap weighted indices will tend to give you exposure to more of the large SOEs, which some consider to be poorly aligned with the interests of minority shareholders (i.e. everyone who isn’t the Chinese state…),” he said.

Funds that track the CSI 300 index, which tracks A-Shares listed on the Shanghai and Shenzen exchanges, could a good choice here – the Xtrackers CSI300 Swap UCITS ETF (XCHA) being one of them – but Seager-Scott said more product choice is needed in this space.

Future developments

Yet there is much product development going on for investors wanting to gain access to China, including ETFs tracking indices designed to capture specific market characteristics, such as growth, momentum or low-volatility, as well as providing a tilt towards specific themes, such as digitisation or demographics.

Rick Chau, head of Asia Pacific sales at Qontigo, the parent company of STOXX, said: “Index providers offer customisation services that allow ETF providers to fine-tune ETF strategies and products to meet the requirements of their end-user investors.

“The STOXX China A Minimum Variance index used by China Post Global as the underlying index is one such example of providing global investors access to the China A-market but with an underlying strategy to minimise volatility.”

As investors across the globe increasingly seek to include ESG considerations into their investment portfolios, this could be another area of development for Chinese equity ETF providers.

Leitao said: “A noteworthy fund for ESG-conscious investors is the KraneShares MSCI China ESG Leaders UCITS ETF (KESG) that was launched earlier this year. The strategy leverages MSCI research to systematically exclude ESG laggards in the Chinese equity market, and stands as a positive direction for ESG product launches in this space.”

One thing is clear – there is still much room for growth both for the Chinese market and the products tracking it. As China’s economy stages its quick post-virus recovery, it may be time for European investors to finally close their underweights and dive back into Chinese equities.