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China Opens its Onshore Equity Markets to Foreigners

China enthusiasts can now gain access to China's A-share market via ETFs.

Patricia Oey, 07/25/2014

Morningstar Take
Five exchange-traded funds that provide direct access to China's onshore equity market (China A-shares) have launched over the past year. These launches are notable in that they provide access to an asset class that in the past had been inaccessible to foreign investors. While there is a degree of novelty to these products, China A-shares are an extremely niche asset class and more suitable for those who are very familiar with risks and opportunities of investing in the emerging markets, and especially in China. DB X-trackers Harvest CSI 300 China A-SharesASHR (report below) is currently the largest A-share ETF with about $200 million in assets. The other A-share ETFs are significantly smaller and have seen very low asset inflows.

DB X-trackers Harvest CSI 300 China A-Shares provides cap-weighted exposure to the onshore (A-shares) Chinese equity market, where foreign investors have historically had very limited access. 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 ETF exists (along with a handful of others that were also launched over the past year) is evidence that China is slowly and carefully trying to open up its capital markets.

At this time, investors have access to Chinese companies via shares listed in Hong Kong (and New York, to a much smaller extent). Some Chinese companies have dual onshore and offshore listings (many in the financial and energy sectors) and some companies are listed only in China (typically mid-cap names), Hong Kong (typically the largest state-controlled firms), or New York (typically Internet and consumer companies). Overall, this CSI 300 Index and the MSCI China Index (which is composed of Hong Kong-listed Chinese companies) have about a 40% overlap. For an in-depth explanation of the differences among the onshore A-shares and B-shares, and the offshore H-shares, red chips, and P-chips, please refer to my Hong Kong-based colleague Jackie Choy's report on the topic.

China A-shares (as measured by the MSCI China A Index, which is very similar to the CSI 300 Index, but priced in U.S. dollars) have had a low 38% correlation to the S&P 500 over the past five years. The correlation is much lower than the 65% correlation between the MSCI China Index and the S&P 500, which would imply that an investment in China A-shares could provide diversification benefits. The opening of the A-share market to foreign investors may drive up correlations in the coming years, but it will likely be a slow process.

As for risk, the MSCI China A Index used to be more volatile than the MSCI China Index, but over the past three years, the annualized standard deviation of returns of the MSCI China A Index was 21%, almost in line with that of the MSCI China Index.

Chinese equities have a relatively short history. The modern day onshore Shanghai and Shenzhen Stock Exchanges opened for trading in 1990 and the first Chinese company to list in Hong Kong occurred soon after. In the early days, it was the larger, fiscally healthier, and politically favored companies who were allowed to list abroad in Hong Kong or New York to draw upon a global investor base. This included companies such as China Mobile CHL and energy firm CNOOC CEO. As a result, Shenzhen- and Shanghai-listed companies tended to be more mid-cap firms. One of the commonly cited reasons for investing in China A-shares is for a more "complete" exposure to the Chinese investment universe. Adding A-shares exposure would also result in a larger allocation in China, which some say would make sense given the size of the Chinese economy relative to the rest of the world.

While it was almost impossible for foreign investors to gain access to China A-shares in the past, more recently, the Chinese government has made some moves to open up the domestic Chinese equity market to foreign investors. Starting in 2002, foreign institutional investors who want to purchase A-shares had to be granted a qualified foreign institutional investor license, or a QFII. Although this program has been in place for more than a decade, the Chinese government has kept investment quotas low, so foreign ownership still accounts for a very small 1%-2% of the local Chinese market. However, the Chinese government is expanding the QFII program (as well as its RQFII program, which is currently aimed at Hong Kong investment firms), as part of its overall efforts to liberalize its capital markets and currency. On a somewhat related matter, index provider MSCI is considering adding China A-shares to the MSCI Emerging Markets Index but is concerned about the current bottlenecks that exist for foreign investors. Some coordination between the Chinese authorities (regarding larger quotas for foreign investors) and MSCI will be needed so that investors will have access to China A-shares should they be added into the MSCI EM Index. Investing in A-shares now before the crowds is another commonly cited reason to buy a fund such as ASHR.

In the past five years to June 2014, the MSCI China A Index has had annualized returns of negative 3.0%, significantly underperforming the MSCI China Index’s 5.0% over the same time period. 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. More recently, at the start of the year, China reopened its IPO market after a 14-month hiatus. This temporary 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 risks common to investing in emerging-markets stocks.

Patricia Oey is an ETF analyst at Morningstar.

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