Q: Why should investors consider gaining exposure to China? What is the opportunity there?
A: We have talked about the opportunity in China for many years, specifically in the A-Share market, which is the mainland Chinese stock market. During the current period of volatility, China performed quite well compared to the US, the emerging and the developed markets. In general, the world underweights China. Its correlation to the S&P 500 is low in most cases, so Chinese stocks offer a portfolio benefit.
Prior to the pandemic, China was one of the fastest growing economies in the world with a large and growing middle class. It has become an increasingly consumption-based economy, moving away from relying too much on the industry. Investing in China makes a lot of sense due to all the economically positive changes there.
The Chinese market represents a huge macro story, while the underweight, specifically in A-Shares, provides an opportunity. Historically, there was no access to that market, so we find ourselves in the confluence of these factors. Mainland China is going through a fundamental shift that puts it on track to potentially becoming the largest economy in the world. That is why it has been such a compelling story for so long. Through the period of volatility, China came out with less volatility.
Q: How is the global pandemic affecting Chinese stocks?
A: Clearly, there have been changes. There is higher uncertainty about the future of trade and the effect of the potential recession. Also, there is a real risk for China to become more isolated, so the risk associated with China is under question. However, China is still one of the fastest growing large economies with a huge, developing middle class. The composition of the economy has shifted towards consumption and is less reliant on the industry. So, even if China becomes more isolated in terms of trade and commerce, that shift will help weather the storm.
The A-Shares, or the Chinese mainland stocks, are highly likely to maintain their low correlation, especially if the consumption-based economy can stand alone and be less affected by the potential decrease in international trade. The diversification benefit of A-Shares is a strong positive factor. Because everybody massively underweights China, there’s room for allocation and for the diversification benefit in most portfolios.
The benchmark that we use, CSI 300, represents the underlying economy. In comparison, the benchmark for the Hong Kong listed Chinese companies has fewer stocks and a much larger weight to financials, especially to a small number of mega-cap financials. Some of CSI 300 outperformance comes purely from the fact that the index is diverse and represents a much broader spectrum of the Chinese economy.
Q: How has the ETF evolved?
A: Historically, there was no access to the A-Shares and there was a liquidity issue. Then a program was introduced, which involved the QFII quota system and a lockup period. That led to weekly liquidity and was an improvement. Later they developed RQFII, or the Renminbi Qualified Foreign Institutional Investor quota, which allows daily liquidity.
That is when we realized that China is fully accessible, so we could structure an ETF around it. We did that in 2012 and that allowed money in and out. It meant that investors could trade on the NYSE and gain exposure to the CSI 300, while buying and selling just like they would for US stocks. The ETF tracks the index and the money flows in and out of China.
But the market has become even more open since we launched. We now have the Hong Kong Connect, which is a connection between Hong Kong and Shanghai and Shenzhen. That means that there is trading between the markets and you do not need a quota. The access to the A-Shares makes it much easier to trade, so China is opening more.
Because of the difficult access in the past, most of the big benchmarks, like MSCI Emerging Markets, did not hold A-Shares. They did not deem them accessible, so they used to hold Hong Kong listed, New York listed, London listed, and Cayman registered Chinese equities. Currently they are adding the mainland shares, so there are billions of dollars of index-tracking assets that will move into Chinese A-Shares as their weight increases in the benchmarks. As that happens, more money will move by the benchmark tracking indexes and, as a result, more money will go into China.
The point is that, if money is moving into China that is a positive factor for China. Importantly, the reason for being added to the benchmark is that China has reached the high threshold of liquidity and accessibility. The fact that MSCI and FTSE are adding A-Shares to their benchmarks means that the Chinese A-Shares have passed a high hurdle to be allowed in these portfolios. Once China became accessible through different venues, bringing your money back has not been an issue.
Q: What is the main difference between a Chinese A-Share ETF and other ETFs?
A: The only difference vs other traditional ETFs is the access via Hong Kong Connect or through your RQFII. It is not different in essence; it is just a different mode of access. For example, if you had a German ETF, the market makers will deliver a basket of German stocks. Chinese stocks cannot be delivered “in-kind”; market makers give us cash and we buy the stocks through our access point. So, it is not a meaningful difference.
Regarding the difference between ASHR and other A-Share ETFs, this it is the largest and most liquid ETF with a strong options market around it. Many investors like to use the options market around their ETFs, because you hedge or increase returns with options. Investors can also lend ASHR to traders that have gone short and get paid for it. Overall, there are many things you can do with ASHR more efficiently than with other A-Shares, simply because it is the largest and most liquid ETF.
Q: How does volatility impact the Chinese stock markets?
A: China A-Shares beat US and other world benchmarks in 2019 and have exhibited less volatility in 2020. There was a period, when the Chinese currency was strengthening at about 2% every year, so if you invested in China, you could add 2% because your assets are overseas and you could buy your dollars back at a lower price. The A-Shares have also provided diversification benefits in difficult times. At times, they can be quite volatile, but they can improve the risk-return of a portfolio as a complement or as an uncorrelated asset.
Overall, their contribution to a portfolio has been positive. We feel that with the size of the Chinese economy and with the fast growth of the middle class and the infrastructure, most portfolios are underweight their natural market cap weight. That is why it is compelling to look at China. I think that people cannot afford to just ignore it.
Because China is becoming increasingly accessible, the index providers are more willing to add A-Shares. They have started doing that already. So, the more accessible the market is, the more benchmarks add China and, as a result, more money is invested in China. That improves the liquidity and the robustness of the stock market. Of course, there is uncertainty around the outcome of the current situation, both globally and to China.
Q: How is this ETF different from the actively managed funds focused on mainland China?
A: There aren’t any mutual funds that are based on A-Shares and provide this type of exposure. We could make the argument that it is an emerging market, which maybe is less efficient, and provides more opportunities for active managers. Over time, not all actively managed funds outperform the passive ones, so this comes back the standard discussion around active versus passive management. There is always a case for active and passive.
However, in this case it passive and there is no realistic competitor. ASHR is a highly liquid ETF, representing a highly liquid secondary market, a highly liquid options market, and a healthy currency exchange. There are ETFs that I call quasi futures because they represent a price-discovery vehicle for their asset class. I believe that ASHR is one of those products. For the Chinese A-Share market, this is the number one vehicle outside of Asia.
Q: Do the owners of Class A shares enjoy additional rights as shareholders?
A: For Chinese companies, there are many share classes. When Chinese companies went public, there wasn’t much access to global capital. As a result, some companies decided not to be listed in China, but to go overseas. They issued A-Shares, when listed domestically, or H Shares, when listed in Hong Kong. Then there are companies like Baidu and Alibaba, which listed in New York and are called N shares. There are other share types; there are things like Red chips and P chips, etc. A company may be registered in the Cayman Islands, but may be listed on the Hong Kong Exchange and have Chinese ownership.
To invest in the US markets, you buy stocks on NYSE, Nasdaq, Cboe, all in the US. To invest in China, you can buy stocks in Shanghai and Shenzhen, or in Hong Kong, New York, and London. All these different share types make investing in China complicated. That distinction developed organically, when at different times different companies decided to list in different places. In the future, the stock market is likely to develop as in most other countries, where there are one or two exchanges in the home country, where the companies are listed.
But the A-Shares are the local mainland stocks; they represent a larger more diverse universe. There are only 150 so called H, Hong Kong, shares to choose from and that is how most indices had to access China. Due to their limited number and concentrations, the H Shares are not a good viewpoint towards China; these are just the companies that chose to list in Hong Kong. With the A Shares, we get more companies and a better sector allocation based on the broader Chinese economy.
We offer a product with the ticker CN, where the idea is to buy all the different share classes, so you don’t have to worry about A, H or N. The A Share product is our pure play, which invests in the top mainland A-Shares, which most investors are missing, while CN provides access to all the Chinese companies, regardless of where they are listed.
Q: How do you narrow down the list of companies from 3,000 to 300?
A: CSI does that through its methodology, which is not materially different from the methodology of the major indices in the US. They look at market cap, liquidity, and other factors to make sure they meet the benchmark criteria. The Chinese stock market is a highly liquid market, so the top 300 stocks are incredibly liquid. The CSI 300 Index in China is equivalent to the S&P 500 index in the U.S. It is managed by CSI.
Q: Do you prefer state-owned or non-state-owned Chinese companies?
A: The state ownership results in an interesting dynamic. Most Chinese companies have some amount of state ownership. In general, the state-owned companies tend to be a little less dynamic and efficient, but the Chinese economic policy tends to support them. The others are nimbler and faster growing. Over time, we have found that the mix of state-owned and non-state-owned enterprises is a healthy mix, because you get some support for the state-owned companies and some dynamism and growth opportunity for the non-state-owned ones. So, the ownership is not that much of a concern; it is an interesting characteristic.
In the Chinese stock market, there are fewer short or levered positions compared to many developed markets. That may have contribute to less panic in a selloff. I am not saying that is necessarily good or bad, but it is interesting. While it’s a different market with many things to understand and know, some of those characteristics make it such a unique and uncorrelated market. That is what I find exciting about China.
Q: What are the differentiating characteristics of the underlying benchmark?
A: When we launched the fund, there was no precedent for accessing A shares in this wrapper outside of Asia. That was the Chinese benchmark, or the benchmark tracking the most assets in Asia. Regarding the Hong Kong markets, we felt that 150 stocks wasn’t enough to represent what is ostensibly the second biggest economy in the world. We wanted to focus on the large cap universe, because we had also launched the small and mid-cap products. Our objective was to build a product that would be familiar to products investing in the US, Germany, or the UK. For an economy as large and diverse as the Chinese, we felt that the 300 was right in the sweet spot. It was a benchmark, which recognized and fit the definition of a good, large-cap fund.
The other important factor was that MSCI wasn’t including A shares and our ambition was to bring index providers who were not yet including A shares. Since, they’ve started to add A shares. They couldn’t add the full contingent of Chinese A-Shares starting from zero, because that could be disruptive to the markets. So, they worked out a methodology to slowly build that position. It was logical to include stocks available through Hong Kong Connect first, because they can’t make assumptions about what investors have access to. We have access to everything, so we able to offer A shares directly for all without delay.
My point is that the index providers are doing this the right way, slowly built up to allow investors to move into A-Shares in a robust way. First they looked at what’s available through Connect. Then they imposed strict size and liquidity limits. The idea to bring and pick stocks is similar to the CSI 300. I believe that once they include everything, their index would hold about 400 stocks, compared to the CSI 300 stocks. Right now, their index holds 230 stocks.
MSCI has an index that is moving toward completion, so we brought this product also to support asset managers who are following those benchmark.
Q: What are some of the functions of the Xtracker?
A: The main distinction is that it is the primary A-Share vehicle outside of Asia, so it has the most liquidity with buyers and sellers. As a result, institutional investors can express tactical or short positions and, therefore, the market will be able to lend and borrow those A-Shares. So, for a buy and hold investor, there is an opportunity to lend those shares out to the market to whoever is going short, and the A-Share is one of the most lucrative stocks to hold from a borrower’s standpoint.
At the height of the crisis in China, we saw people willing to pay to borrow A Share. The borrow rate for ASHR has peaked somewhere above 43% annually, albeit only for a few days at a time. Not all the clients get the benefit of lending. That’s why A-Shares is a good product for institutions - they get the position and the diversification they want, while also getting paid to lend the fund.
The second benefit related to the liquidity is the options market, which is a popular strategy on any liquid asset. There are short sellers, long sellers and people wanting to hedge those risks.
Q: Is ASHR currency hedged like many of the Xtrackers?
A: Yes, it is a standard international ETF, which gives exposure to equities. There are two components of the risk - the stocks themselves and bringing back the return when you sell. Its price moves on stocks and currencies, just like the price of most large international ETFs.
The Chinese currency has been allowed to move only in narrow bands, so that risk can be more volatile. Although we have been among the leaders in currency hedging, this is one of the markets where we don’t feel as strongly about currency hedging, mainly because the Chinese currency has been artificially weak and generally controlled. If the risk is that the USD gets stronger, you don’t want to hedge. So, there is an asymmetrical risk for the Chinese currency. In the long run, it is more likely to rise, so I am not too concerned about the currency exposure for A-Shares.
