Not just another BRIC in the wall

A developing economy with high growth prospects renders China an attractive market to tap through ETFs, as Emma Dunkley reports

China is being hailed as one of the countries leading the way out of the global recession, and is at the fore of the rapidly rising emerging markets. With plenty of economic growth potential, industry players dub China as a lucrative market and an integral part of investors’ portfolios. 

“China is going to experience the Japan story. Between 1950s and 1960s, Japan had tremendous performance and those who had missed it thought it was all over,” says Evercore Pan-Asset Management chief executive Christopher Aldous. However, he explains Japan then went on to produce excellent returns right up to the late 1980s. “China is now in that position – it’s going to surge away for at least another decade in our view.”

Although China is one of the largest economies by Gross Domestic product (GDP), accounting for around 6% or 7% of global market capitalisation, it is relatively under-represented in many indices says Aldous. He adds: “We have the preponderance of our investments in Asia, so China is bound to play a bigger role in our portfolio, along with India, due to the size of their populations and economies.”

In terms of gaining exposure to the growth opportunity afforded by China, Aldous is a strong advocate of ETFs. He says: “It’s a cheap, easy way to gain access to the market and as London-listed ETFs are highly used and liquid, spreads tend to be tight. It also means we can deal cheaply on a local exchange.” He adds that gaining country access via an ETF returns the performance of the index as well as giving a proxy exposure to the underlying currency. 

Top performer

In the three-month period, the best performing fund was the Lyxor ETF Hong Kong, returning 18.18% according to Morningstar data. The fund, which has around €200m in assets, tracks the Hang Seng index, comprising a mixture of H-shares and Chinese companies. Lyxor Asset Management director Claus Hein says: “There are foreign restrictions to investing directly in Chinese shares listed on local exchanges such as Shanghai and Shenzhen. However, international investors can purchase H-shares which are stocks issued by companies incorporated in mainland China, but are listed and traded on the Hong Kong Stock Exchange.”

Yet he explains that there has been a lot more interest in Lyxor’s pure H-share tracking vehicle, the China Enterprise fund, which tracks the Hang Seng Enterprise index and aims to deliver the performance of mainland China companies with H-share listings in Hong Kong. Hein adds: “We continue to see significant demand for the Lyxor ETF China Enterprise as an efficient tool to gain intraday access to Chinese equity. The liquidity available via the H-shares market in Hong Kong is imperative for the daily trading of the fund and its long term growth.”

The Lyxor ETF China Enterprise had €320m in assets at the beginning of the year, which increased to €720m as of the end of September, marking a rise of about 125% says Hein. In comparison, the underlying index was up 60% in the same period, showing that a significant number of ETF units were created in the fund. According to Morningstar data, the fund was one of the better performing in the one-year period, at 54.17%. 

The road to China

In order to gain access to China, ETFs can own offshore or onshore Chinese equities. iShares head of sales strategy Europe Nizam Hamid says: “The red chip equities and H-shares, which are offshore securities, are easy to own from a physical perspective, meaning the investor has all the benefits of physical ownership of the underlying equities.” 

For example, the iShares FTSE Xinhua 25 consists of the largest 25 Chinese companies, including H-shares and red chip shares, ranked by market capitalisation. The individual components are capped at 10% of the total index. Hamid says: “By having a cap on the exposure, it makes it easier for the ETF tracking the index to be Ucits compliant.” He adds some of the benefits of physical ownership include greater liquidity and the ability to trade the underlying equities in the local markets.

According to Hamid, the FTSE Xinhua 25 ETF trades about $800m a day in the US and around €8m a day in Europe, with over €660m in assets under management. He explains the European ETF does not trade as much as the US listed product, but adds there is a lot of over the counter trading in Europe which does not get reported, as opposed to the US. Nonetheless, Hamid highlights the growth opportunity offered by China renders it a significant investment. He says: “There’s higher volatility investing in China as an asset class, but it has higher growth prospects, so we see China and the other emerging markets forming an important part of peoples’ portfolios.”

ETFs which gain exposure via on-shore securities, such as the iShares FTSE Xinhua A50, typically require a swap. Morningstar data shows the iShares FTSE Xinhua A50 fund was one of the better performing ETFs in the longer term three-year period, returning 148.61%. Hamid says: “In order to own onshore Chinese equities in an ETF, you need a swap-based structure. The FTSE Xinhua A50 provides exposure to domestically listed Chinese securities through promissory notes, with 10 or 11 different swap providers.”

Thurleigh Investment Managers chief investment officer Charles MacKinnon says the firm is now buying the iShares FTSE Xinhua China 25 on top of the broader emerging markets fund it already owns, in order to go overweight China. He says: “Our core holding in the emerging markets is in the broader emerging markets ETF and ultimately, it has done very well.” He adds that it is beneficial to own the broader emerging markets fund, rather than just country specific ETFs, because it has lower volatility as a result of the constituent countries not moving in tandem. While MacKinnon acknowledges the China index will have more volatility than a US one, he notes China provides a great opportunity to achieve growth. 

Chart: ETFs in China