Proposed A-shares ETFs could transform investors' approach to China

They would gives Westerners access to a broader swathe of the economy

By Carl O'Donnell

Feb 27, 2014 @ 12:02 pm (Updated 3:08 pm) EST

China, ETFs
Bloomberg News

Filling the pipeline of SEC filings are more than a dozen new ETFs that could potentially change the way investors access Chinese stocks.

The proposed funds, which total at least 15 — mostly from Van Eck Associates and Deutsche Bank AG — promise to offer ETF investors fine-grained exposure to the newly liberalized market for Chinese A shares, which are stocks traded on exchanges in Shanghai and Shenzhen.

The ETFs pitched by Deutsche Bank, for example, target individual sectors ranging from health care to financials to consumer discretionary. Another fund also targets small-cap stocks, according to SEC filings.

“I think what we see here is a natural evolution that has played out time and time again,” said Ben Johnson, director of passive fund research at Morningstar Inc. “The first ETFs are done at a very high level and others get finer and finer as needs dictate.”

For investors seeking exposure to the full spectrum of Chinese equities, A shares are essential. The majority of the country's stocks are only listed on the A-share marketplace, said Amrita Bagaria, an ETF product manager for Market Vectors, a unit of Van Eck Associates that markets ETFs.

These companies are also typically more consumer-oriented, a potential draw for investors betting on China's successful transition to a consumer economy, said Mariana Bush, a senior analyst of exchange-traded products for Wells Fargo Advisors.

“A lot of investors who say 'I own China' don't really own China,” said Ms. Bagaria. “They are missing the two-thirds of the equity market that are A shares.”

The introduction of these proposed ETFs would be a big departure from the current offerings. The two major A-shares ETFs on the market today — Market Vectors' ChinaAMC A Share ETF (PEK) and db X-trackers Harvest CSI 300 China A-Shares Fund (ASHR) — offer broad exposure to China by tracking the CSI 300, a market-cap-weighted index of the country's 300 largest companies.

The CSI 300, however, offers inordinate exposure to China's state-owned enterprises, which will play a diminished role in the economy as the country's recent spate of reforms kick in, according to Patricia Oey, a senior fund analyst at Morningstar.

“In the broad benchmarks, there is certainly a very large representation of state-owned enterprises and there are certainly risks associated with owing those particular equities,” Mr. Johnson said.

The proposed funds, meanwhile, offer more surgical exposure, allowing investors to place long-term bets on the country's shift to a consumer economy, experts said.

As China reels in the investment rate of nearly 50% of GDP that propelled the country's boom, the engine of growth will shift toward household consumption. As a result, the service sector — and other industries exposed to consumer demand — should enjoy a big boost, said David Dollar, an economist at the Brookings Institution.

“Many of these funds seem to buy into this notion that China is re-balancing and that certain types of industries will do well,” Mr. Dollar said.

The db X-trackers Harvest China Small Cap, for example, tracks the performance of the 500 smallest and most liquid stocks in the A-share marketplace. Small and midsize Chinese companies are rarely state-owned, Mr. Dollar said.

Moreover, small-cap stocks are more likely to offer exposure to consumer demand, added Todd Rosenbluth, director of ETF and mutual fund research at S&P Capital IQ.

Many of the other indexes tracked by the funds, including health care, finance, consumer discretionary and consumer staples, also stand to benefit from a rise in household consumption, Mr. Dollar said.

The question is whether investors will bite, Mr. Rosenbluth said. On one hand, the existing funds, ASHR and PEK, have enjoyed reasonably strong inflows, with ASHR reaching about $166 million from $108 million last November, according to Morningstar. PEK has attracted net inflows of $28.2 million since 2010.

On the other hand, Chinese equities haven't performed well for years, Mr. Dollar said. The MSCI Golden Dragon Index, for instance, is down 4.6% year-to-date through Feb. 26, and 0.97% over the past three years.

“Much of the growth in assets seems to be due to the fact that these funds are new and offer investors first-time exposure to certain Chinese securities,” Mr. Rosenbluth said. “It's not as if these investors were chasing hot performance.”

The market for Chinese A shares only opened up in 2011, when China's government established a pilot program allowing a trickle of foreign investment. Over the years, the investment quota has been steadily increased, allowing more foreign companies to access the market, according to a report by Morningstar.

That increasing openness might be a silver lining amid the country's weak stock performance. Part of the reason Chinese stocks are so sluggish, despite years of robust economic growth, might be that the marketplace is thin and may not fully represent the larger economy, Mr. Dollar explained. That's precisely the sort of problem larger capital inflows could help change, he said.

“To date, getting additional allocations of quota hasn't been an issue,” Mr. Johnson said. “[The Chinese] are very keen to lay out the welcome mat.”