Courtesy of Dennis Hudacheck
Investing in China is tricky. There are now more than 20 China-focused ETFs to choose from, ranging from size and style funds to sector-specific funds. As if sifting through expense ratios, liquidity and holdings isn’t enough, China investors have another big, fundamental factor to consider: Chinese share classes.
Foreign investment in China is still restricted: A U.S. investor cannot simply open a brokerage account and trade locally listed Chinese shares. As a result, there are multiple shares classes of Chinese companies floating around on various exchanges, allowing investors different ways to access this complex market.
Depending on the underlying index that an ETF tracks, some funds are eligible to hold only a certain type of shares. This matters because the different share classes an ETF is eligible, or ineligible, to hold can significantly impact the fund’s performance, and ultimately determine the type of Chinese companies in the portfolio.
Chinese share classes, especially as they relate to ETFs, are often misunderstood—or worse, ignored altogether. We at IndexUniverse think investors deserve better, so we prepared this document to provide insight and guidance on the topic to help investors make an informed decision on choosing the right China ETF.
For the most part, local investors in China buy what are known as “A-shares.” These are the shares of companies traded on the domestic Shanghai and Shenzhen stock markets, quoted in renminbi. Except for a select few qualified foreign institutional investors (QFIIs)—and via some unusual products —most investors cannot readily buy A-shares.
Due to this restriction, most ETFs currently access the Chinese market through shares of Chinese companies listed in Hong Kong, the U.S. or a special “B” share class traded in Shanghai or Shenzhen. These “investable” shares consist of H-shares, red chips, P-chips, B-shares and N-shares.
Let’s look at each of these shares below, because grasping their differences is crucial.
- A-shares: Chinese companies incorporated on the mainland and traded in Shanghai or Shenzhen, quoted in RMB.
- B-shares: Chinese companies incorporated on the mainland and traded in Shanghai and quoted in USD or traded in Shenzhen and quoted in HKD (open to foreign ownership).
- H-shares: Chinese companies incorporated on the mainland and traded in Hong Kong.
- Red chips: State-owned Chinese companies incorporated outside the mainland (mostly in Hong Kong) and traded in Hong Kong.
- P-chips: Nonstate-owned Chinese companies incorporated outside the mainland, most often in certain foreign jurisdictions (Cayman Islands, Bermuda, etc.) and traded in Hong Kong.
- N-shares:Chinese companies incorporated outside the mainland, most often in certain foreign jurisdictions, and U.S.-listed on the NYSE or Nasdaq (ADRs of H-shares and red chips are also sometimes referred to as N-shares).Share Classes And ETF Breakdown
It may come as a surprise that some of the most popular China ETFs are not eligible to hold all investable shares. For example, the $6.1 billion iShares FTSE China 25 Index Fund (NYSEArca: FXI), which holds 25 of the largest and most liquid Hong Kong-listed Chinese shares, is only eligible to hold H-shares and red chips.
This means China’s largest Internet company, Tencent Holdings, is excluded because it’s classified as a P-chip, even though Tencent has a market capitalization of $64 billion, which would put it within the 25 largest H.K.-listed Chinese companies.
The key to knowing which share class a fund is eligible to hold lies in knowing which index the fund tracks. FTSE, a leading index provider in the space, to date has considered P-chips to be Hong Kong companies, and has listed them in developed market Hong Kong indexes instead of their China index series.
Therefore, ETFs that track FTSE’s China indexes, such as FXI, are only eligible to hold H-shares and red chips, which limit their scope, as the indexers’ classification methodology determines where that company sits in their global breakdown.
The iShares FTSE (HK Listed) Index Fund (NYSEArca: FCHI), a “total market” version of FXI with over 120 holdings, is in a similar boat. So again, it misses out on important P-chip names like Tencent Holdings, Belle International, Want Want China, Gome Electronics and Geely Automobile.
It’s worth noting that on June 18, 2012, FTSE announced that it will reclassify P-chips from Hong Kong to China in their FTSE Global Equity Series, effective March 2013. Then on Sept. 26, 2012, it extended that reclassification announcement to its FTSE China 25 Index. This means that P-chips, such as Tencent, should be eligible for inclusion into FXI once this reclassification takes effect in March 2013.
MSCI’s scope is slightly wider than FTSE because its indexes are eligible to hold P-chips. Still, MSCI does not include N-shares in its indexes. According to MSCI’s methodology, a security’s country classification is determined by the location of its incorporation and primary listing.
Many N-shares are incorporated in tax havens like the Cayman Islands or Bermuda, and have their primary listings in the U.S. (N-shares and the regulatory and legal risks associated with them are discussed in detail below).
Therefore, ETFs like the iShares MSCI China Index Fund (NYSEArca: MCHI) provide exposure to mega-cap P-chips like Tencent Holdings, but exclude many significant N-share technology names like Baidu, Sina and NetEase. This example also shows that significant sector biases result from the share-class issue.
Investors looking to get a broad mix of all investable Chinese shares have options, such as the SPDR S&P China ETF (NYSEArca: GXC). The $875 million GXC holds all investable shares, providing the most comprehensive exposure to the Chinese market currently available to U.S. investors.
Other cap-weighted options that provide comprehensive share-class exposure include the Guggenheim China All-Cap ETF (NYSEArca: YAO) and the Guggenheim China Small Cap ETF (NYSEArca: HAO). Global X’s suite of China sector ETFs also pulls its holdings from a universe of all investable shares.
A-shares aren’t entirely inaccessible to ETF investors. Those looking to dive into the A-share market have one option: the Market Vectors China ETF (NYSEArca: PEK), which enters into swap agreements with QFIIs, in order to track the CSI 300 Index. But investors in PEK need to weigh some factors.
First, because it utilizes a swap agreement, the fund comes with counterparty risk. PEK currently has one swap counterparty, Credit Suisse. This means if Credit Suisse fails as a company, or fails to deliver on its end of the deal, the shareholders could be affected.
PEK’s counterparty also gains access to A-shares as a QFII, and QFIIs have quotas (currently $1 billion per institution). So when demand is especially strong for A-shares, swaps get more expensive—which can cause the fund to trade at premiums to its net asset value.
From its inception in late 2010 until August 2011, PEK often traded at premiums north of 10 percent. As China eventually increased its QFII quotas and demand for A-shares decreased with the slowdown in Chinese growth, premiums have since fallen.
It’s worth noting that in July 2012, Van Eck Associates was granted QFII status for $100 million, meaning it will likely be the first U.S.-based ETF provider to have a physically backed China A-share fund.
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