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Van Eck Cracks the Code on China A-Share Exposure

New Van Eck ETF provides exposure to the inaccessible 25% of emerging markets.

Abraham Bailin, 10/25/2010

For some time now, fund providers have attempted to open the international forum to U.S. investment. Much of the recent activity has been focused on the emerging-markets space. 

Fund providers have continued to launch broadly based funds, in addition to the many region- and nation-specific vehicles that slice the emerging markets into increasingly niche segments. Investors concerned with maintaining international exposure will be interested to find that they have been missing access to nearly one fourth of the emerging-markets universe.

The Missing Piece
The Chinese economy ranks among the largest in the world and accounts for nearly 33% of the emerging-markets space by market capitalization. A majority share of China's market, however, has been cut off from the broad international investing community by regulatory capital controls imposed by the Chinese government. This 'A-share market' commands a 24% of the emerging-markets universe and the lion's share of China's broad domestic-equity pool.

A select few international participants, known as QFIIs, have been granted access to these A shares. Through swap contracts with these QFIIs, Van Eck's Market Vectors China A Share ETF (PEK) provides broad A-share exposure to U.S. investors, tracking the CSI 300 Index in an exchange-traded fund wrapper.

Levying an expense ratio of 0.72%, PEK tracks a modified free-float market-cap-weighted benchmark that represents the 300 largest and most liquid stocks trading on China's domestic A-share market. Constituents must generally have been listed for at least three months, unless their average daily market cap ranks among the A-share market's top 30. The index is reviewed semiannually in January and July but generally maintains a heavy overweighting in the financials sector. Financials, industrials, and consumer discretionary constitute the largest sector weightings, holding 34.2%, 17.0%, and 9.2%, respectively.

QFII Status
This fund's advisor is not currently a QFII, so PEK will not invest directly in the A shares of its underlying index constituents. Instead, PEK will invest no less than 80% of total assets in vehicles whose economic characteristics are substantially identical to the securities that comprise its benchmark index. Until and unless the advisor receives QFII status, the fund will engage in swap contracts that replicate returns of the same index. Investors should note that A-share availability is scarce, and the ability of this fund to meet its investment objective is intimately tied to its ability to find appropriate swap counterparties.

The fund's swap contracts are collateralized by the fund's custodian, Bank of New York, minimizing counter-party risk, and the fund reserves the right to tap a multitude of individual QFIIs as swap counterparties. The total QFII quota amounts to nearly $30 billion, so capital liquidity shouldn't be a major concern anytime soon, but there are reasons for pause.

Taxes and Premiums
PEKs tax status should be considered a major investor concern. Swaps expire, and subject to the requirements of the 1940 act, may also need to be reset from time to time. These expirations will create taxable events.The fund expects to distribute capital gains to its shareholders along with net investment income at least annually, and shareholders will be liable for U.S. federal income taxes at ordinary income rates as these distributions are paid. This schedule should generate short-term capital gains, taxable at ordinary income rates that are due to increase in 2011.

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