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By Christine Benz and Michael Rawson, CFA | 07-08-2015 03:00 PM

Behind Vanguard's Surprising China Decision

Is it out of character for the normally conservative fund firm to add volatile China A-shares to its Emerging Markets Index Fund?

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Shortly before the Chinese market began its current freefall, Vanguard announced plans to add China A-shares to its Emerging Markets Index Fund (VEMIX). Joining me to discuss this and other news at Vanguard are Bridget Hughes and Michael Rawson.

Bridget and Mike, thank you so much for being here.

Bridget Hughes: Thank you, Christine.

Mike Rawson: Thanks for having us.

Benz: So, the Chinese market has really been making headlines. Mike, let's talk about Vanguard's announcement; but before we get into the specifics of that, let's talk about what China A-shares are for people who haven't been following this too closely.

Rawson: Unlike stocks that trade in the U.S., which are you pretty much free to trade, you are not free to trade stocks that trade in mainland China, which are known as China A-shares.

Benz: So, U.S. investors--

Rawson: U.S. investors, we cannot freely buy and sell those securities. There are capital controls that prevent us from doing that. Now, you can trade more freely shares that trade in Hong Kong, and there have been Hong Kong-based funds for some time. But funds have not been able to access the A-shares in China until just recently. China is attempting to liberalize its market, open up its economy a little bit more, and encourage more stock market investments.

Benz: So, these A-shares are going to be added to the FTSE Index that the Vanguard fund tracks. That's not happening until later this year, though, right?

Rawson: When we say that FTSE is making this decision, they are really making it in concert with Vanguard. Vanguard has a lot of influence over the decisions FTSE is making. It's a little bit unique because MSCI is a little bit more independent than FTSE in this regard. MSCI has decided not to add these shares at this time, so it's quite surprising that Vanguard is going to go ahead and do it because Vanguard is usually very conservative. They plan with FTSE to begin adding China A-shares to their emerging-markets index slowly and in increments to bring it closer to what would be more of a market-cap weight versus where it is now, which is zero.

The reason why I find this surprising is because Vanguard is a very conservative firm, they have a conservative culture, and they don't really like to get into speculative markets. Sometimes, they will close a fund or maybe not launch a fund in a hot area just because they think investors might get burned by the market froth, but here their equity team has decided to go ahead and add these A-shares.

If you look at some of Vanguard's past decisions when they've built funds--if you look at their international-bond fund, for example--they decided to do currency hedging just to tamp down on the volatility. So, I think there is a little bit of a difference in culture between Vanguard's fixed-income team and their equity team. The equity team seems a little bit more adventurous here, and I find it surprising. What's also surprising is that they were going to add it to their emerging-markets fund, but not their total international stock market fund. This is surprising because typically these subcomponent funds add up to equal the total, and that wouldn't be case once they made this change.

Now, fast-forward just one month later and already China seems to be in a panic over the selling that's going on. Stocks are down tremendously--30% in a short period of time. However, if you look over the past year or two, stocks are still doing pretty well. So, you wonder, "Why is China being so heavy-handed with its market intervention?" This is QE on steroids: They are preventing people from trading or selling certain securities; they are trying to boost shares by buying. Vanguard has got to be thinking to themselves, "What are we getting into here?" Now, with an ETF, you really can't have this kind of market closure. We see what's happening right now with the Greece ETF; the market closes and, all of a sudden, you have an ETF trading at a premium or discount. Now, it looks like a closed-end fund. People start to worry. People can get burned. So, it will be interesting to see how Vanguard handles this.

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