China A-Shares in spotlight, returns lag

An investor walks past an electronic screen showing stock information at a brokerage house in Nanjing, Jiangsu province, January 19, 2016.
China Daily | Reuters
An investor walks past an electronic screen showing stock information at a brokerage house in Nanjing, Jiangsu province, January 19, 2016.

MSCI's decision to add China A-shares to its emerging markets index is big news. It will expand access to China's mainland stocks to a broader audience and increase exposure to China in that index to nearly 40 percent.

As CNBC estimates, there are some $2 trillion of assets in index mutual funds and ETFs benchmarked against the MSCI Emerging Markets Index today. And analysts everywhere are forecasting billions of dollars in asset flows following the A-share inclusion. This is a big deal in the indexing world.

But the reality is that ETF investors have long had direct access to A-shares. Funds like the Deutsche X-trackers Harvest CSI 300 China A-Shares ETF (ASHR) and the KraneShares Bosera MSCI China A Share ETF (KBA) have offered exposure to China's mainland market since well before the MSCI move.

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Both funds also have a relatively strong following. For single-country ETFs — which many still consider too niche or too narrow in focus to truly go mainstream — ASHR is already the fifth-largest China ETF today, with $371 million in assets, while KBA, at No. 7, has $157 million.

Surprising performance leaders

There's another interesting point here. In 2017, with all eyes on the recovery in emerging markets in the rush to capitalize on attractive valuations, and on the much-awaited MSCI decision on A-shares after years of mulling it over, it's funds that exclude A-shares that are leading in performance.

Consider that two of the best-performing China ETFs year-to-date are the KraneShares CSI China Internet ETF (KWEB) and the WisdomTree China ex-State-Owned Enterprises Fund (CXSE). Both of these ETFs have delivered more than three times the returns of A-share ETFs this year. They are also significantly outperforming the largest China ETF, the $3.2 billion iShares China Large-Cap ETF (FXI).

The chart above tells us that, in 2017, mainland China stocks and Hong Kong–listed stocks have delivered pretty similar results — ASHR and KBA versus FXI.

It also tells us that, when it comes to sectors leading performance in the Chinese market this year, none has been stronger than technology and, in particular, the internet. KWEB, launched in 2013, is the only ETF to zoom into China's internet segment.

With more than $525 million in total assets, the fund owns companies like Alibaba, Baidu and Tencent — some of the market's leaders this year amid strong earnings growth, and the drivers of KWEB's outperformance relative to other funds.

KWEB, which invests in Hong Kong–listed stocks and U.S.-listed companies, known as N-Shares, is in fact one of the 10 best-performing ETFs this year, period.

All about consumers

What KWEB and CXSE have in common beyond significant exposure to technology — about 36 percent of CXSE is in tech names — is a focus on China's consumer story. But what's unique about CXSE is that it's the only fund that goes about tapping into that story by excluding state-owned companies. The fund defines a state-owned company as any in which the government owns a stake bigger than 20 percent.

"People invest in China to tap into consumer-centric growth, particularly the middle class," said Gaurav Sinha, asset allocation strategist at WisdomTree. "One of the best ways to access consumption is to eliminate state-owned companies. They are less efficient, and not as good to shareholders."

That exclusion translates into different sector tilts. Consider that the competing iShares MSCI China ETF (MCHI) has similar allocation to technology, but a bigger allocation to financials than CXSE and a much smaller allocation to consumer sectors. CXSE has three times the weighting to consumer discretionary as MCHI.

CXSE also has no allocation to energy and telecom, which are dominated by state-owned companies. These two sectors represent more than 12 percent of MCHI's sector weightings.

Performance driver

It's that consumer focus that's driving CXSE's outperformance, Sinha says. He estimates that about 70 percent of the MSCI All China Index is tied to state-owned companies. A similar stat applies to FTSE's view of China.

"These indices promise you beta to Chinese growth, but they are giving you beta to Chinese government, and not many people invest in China for that," Sinha said. "Our outperformance is a result of our consumer focus."

To be clear, MCHI also excludes A-shares for now, but the fund is tied to the MSCI China Index. The fund's underperformance relative to CXSE, as seen in the chart below, illustrates what sector tilts and exposure to state-owned names have meant this year.

Charts courtesy of StockCharts.com

In the end, MSCI's decision to add A-shares to its benchmarks is being viewed as a huge positive for investors, and a nod to China's efforts to open its capital markets to foreign investment.

But investing in China can take many forms, with ETFs offering all sorts of access that taps into various share types, sectors and companies. For a complete list of China ETFs, check out our China ETF Channel.

— By Cinthia Murphy, ETF.com

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