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ETF Specialist

Dramatic Moves in Chinese Equities Having Minimal Impact on the Average Investor

China typically accounts for about a 1% allocation in a 60/40 stock/bond portfolio.

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After a tremendous yearlong rally during which onshore China A-share markets skyrocketed some 150%, these stocks have hit an air pocket, sliding around 30% during the last few weeks.

The Chinese government has taken unprecedented and aggressive steps to stem the slide, including buying blue chips outright, loosening margin trading requirements, banning large shareholders and company executives from selling their shares for six months, and allowing around 1,500 companies to suspend trading of their shares.

Whether these moves will shore up confidence among China A-share investors, who are primarily domestic retail investors, remains to be seen. Ironically, one of the drivers of last year's rally was Chinese investors' anticipation of large foreign fund flows into the onshore market in the coming years as China liberalizes its financial markets. Given the recent volatility and heavy-handed response by the Chinese government, foreign investors may remain on the sidelines for the time being. Without this foreign flow "catalyst," domestic investors may remain wary. Suffice it to say that there is an great degree of uncertainty lingering over the Chinese equity market.

Most emerging-markets fund managers are evaluating China A-shares (given the size and importance of the Chinese economy) but have not yet invested in China's onshore market. So investors holding emerging-markets funds have not been directly exposed to this recent volatility. For China exposure, emerging-markets funds primarily hold offshore Hong Kong-listed Chinese companies. While those shares have experienced some volatility, price movements have not been as dramatic as they have been in the onshore A-share market.

It's also important to place these events in their appropriate context. Investors with a 60/40 stock/bond portfolio of broadly diversified index funds will have about a 5% allocation to emerging-markets stocks. This means that Chinese stocks, on average, will account for about 1% of the entire portfolio. So while there have been plenty of headlines about the dramatic moves in the onshore Chinese equity markets, these events have had a minimal impact on the average investor's portfolio, given that 1) most investors do not have direct exposure to onshore China A-shares, and 2) any China exposure via offshore Hong Kong-listed names probably only comprises a very small portion (about 1%) of their total portfolio.

Below is our report on the largest U.S.-listed China A-shares ETF, which provides some background on the China onshore equity markets.

 DB X-trackers Harvest CSI 300 China A-Shares (ASHR) provides cap-weighted exposure to the onshore A-shares Chinese equity market, which includes companies listed in Shanghai or Shenzhen. Historically, foreign investors have had very limited access to these markets. This is because China has a "mostly closed" capital account, whereby investors, as well as companies and banks, cannot move money in and out of the country except in accordance with strict rules. Capital account liberalization is part of China's current reform efforts, and the fact that this exchange-traded fund exists (along with the three dozen or so China A-share ETFs that are listed worldwide) is evidence that China is opening up its capital markets.

Investing in China can be confusing. Currently, most offshore investors get exposure to Chinese companies via shares listed in Hong Kong. This fund, however, invests in the onshore Shanghai and Shenzhen markets, where there is more breadth--the MSCI China A Index (which captures about 85% of the onshore A-share investment universe) is composed of 577 constituents, whereas the MSCI China Index (which captures about 85% of the Hong Kong-listed China equity universe) has 145. That said, firms with a Hong Kong listing typically are larger, more established companies, relative to companies listed onshore. But some Chinese companies have dual onshore and offshore listings, and these dual-listed companies comprise about 25% of the MSCI China A Index and 50% of the MSCI China Index. As for top sector weightings, for the MSCI China A Index, it is financials (31%), industrials (21%), and consumer discretionary (11%). For the MSCI China Index, the largest sector weightings are financials (43%), technology (13%), and telecoms (10%). (This ETF tracks the market-cap-weighted CSI 300 Index, which is very similar to the MSCI China A Index).

As for risk, during the past three years, the MSCI China A Index's annualized standard deviation of returns was 29%, whereas the MSCI China Index's was 17%. China A-shares are more volatile relative to their offshore peers because the onshore market is dominated by retail investors, who tend to be short-term-focused. More recently, volatility in China A-shares has been rising because of uncertainty regarding the regulation and impact of China's capital market liberalization on the local stock markets.

Fundamental View
Chinese equities have a short history. The modern-day Shanghai and Shenzhen Stock Exchanges opened for trading in 1990, and the first Chinese company listed in Hong Kong soon after. In the early days, it was the larger, fiscally healthier, and politically favored companies that were allowed to list in Hong Kong or New York to draw upon a global investor base. This included companies such as  China Mobile (CHL) and energy firm  PetroChina (PTR). Shenzhen- and Shanghai-listed companies, on the other hand, tended to be smaller, less established names.

While it was almost impossible for foreign investors to gain access to China A-shares in the past, the Chinese government has started to open the local equity market to foreign investors. Starting in 2002, foreign institutional investors who wanted to purchase A-shares had to be granted a qualified foreign institutional investor license, or a QFII license. Currently, foreign ownership accounts for just 1% of the local Chinese market, but this is expected to rise as the Chinese government expands the QFII program (as well as its RQFII program, which is very similar), as part of its efforts to liberalize its capital markets and currency. More recently, in November 2014, the Chinese government introduced another access channel for foreign investors with its Shanghai-Hong Kong Stock Connect program. Under this program, investors in Hong Kong and mainland China can trade and settle shares listed on the other market via the exchange in their home market, subject to certain restrictions.

In the 12 months through June 2015, the MSCI China A Index returned 111.9%, whereas the MSCI China Index returned 24.6%. The drivers of performance in the onshore market included looser monetary policy in China and a strong pickup in domestic investor trading activity ahead of anticipated large foreign inflows from the new Stock Connect program with Hong Kong. But the main driver of performance was a surge in margin lending by local brokerages to domestic Chinese retail investors.

Prior to 2014, the MSCI China A Index had significantly underperformed the MSCI China Index for four consecutive years. Reasons for this underperformance include a slowing Chinese economy, falling earnings, and local Chinese investors moving their money into higher-returning investment options such as real estate and wealth management products. In 2014, China reopened its IPO market after a 14-month hiatus. This halt was instituted as the government sought to improve oversight and strengthen regulations over the IPO market, which had been plagued by companies with weak financials. All of these issues highlight the many risks of investing in China stocks.

One of the commonly cited reasons for investing in China A-shares is for a more "complete" exposure to the Chinese investment universe. At this time, overseas China shares account for about 2.5% of a market-cap-weighted index of global equities. Adding A-shares exposure would result in a larger allocation in China, which may make sense given that China is the world's second-largest economy. Index provider MSCI is planning on adding China A-shares to its global equity indexes but is concerned about the access bottlenecks that exist for foreign investors.

Portfolio Construction
This ETF tracks the market-cap-weighted CSI 300 Index, which currently accounts for about 60% of the available market capitalization of both the Shanghai and Shenzhen stock markets. The fund sponsor of ASHR, Deutsche Bank, has an asset-management joint venture in China called Harvest Fund Management, and this entity has a Hong Kong subsidiary, which holds a RQFII license. With this RQFII license, this fund is able to invest directly in A-shares and employ full replication to track its index. This fund has seen strong inflows and at times has come close to hitting its capacity or quota (foreign funds receive quotas from the Chinese government). When this occurs, the fund could trade at a premium to net asset value if Deutsche cannot create shares to meet investor demand. The last three times this fund came close to hitting its RQFII quota, Chinese regulators approved additional quota to the fund's sponsors. Deutsche has said it is currently evaluating the viability of using the Shanghai-Hong Kong Stock Connect program as another channel to gain access to A-shares, in addition to its RQFII quota.

This fund levies an annual expense ratio of 0.80%.

Market Vectors ChinaAMC A-Share ETF (PEK) also employs full replication to track the CSI 300 Index and charges a slightly lower expense ratio of 0.72%. However, this fund is not very liquid. Those who want onshore and offshore exposure in one fund can consider DB X-trackers MSCI All China Equity (CN), which charges 0.70%.

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Patricia Oey does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.