Ok, so now that we’ve established we want to allocate some of our portfolio to Chinese equities, what should we buy? There are thousands of publicly-listed Chinese companies, from great to poorly-managed and everything in between. Of course, just because a company is good doesn’t mean the stock price is attractive. So we are going to start with a passive investment product that should give us diversified exposure to a number of companies, with low cost—and that way we don’t have to worry about picking winners.
But a simple search will reveal that there is an overwhelming number of China ETFs. There are over 50 China-focused ETFs currently available today, and that is just counting the ones that trade on US exchanges. How do we make sense of all these choices and pick the best one or a few? We will do a deep dive on a handful of the biggest, broad-based China ETFs and a few thematic ETFs, which overall give a good approximation of the many choices at hand. We are going to get into the details of underlying indexes that they track, comparing their performance, fees and structures, and take a close look at which companies they actually hold. Along the way, we will also take a brief look at the different exchanges where Chinese companies’ shares trade, the regulations/accessibility for non-Chinese investors.
Where we end up
Before we get into all that, I’m going to give you my conclusion at the beginning so you’re not reading blindly: my two favorite funds are Franklin Templeton’s FTSE China ETF (FLCH) and WisdomTree’s China ex-State-Owned Enterprises Fund (CXSE). Franklin gives you a broad-based total China market exposure at the lowest cost of all peers while the WisdomTree fund gives you greater focus on higher-performing tech and consumer stocks while still offering lower fees than most of the funds other than Franklin. Either one or both of these funds would be a great way to get broad exposure to China with returns similar to or better than market at low cost.
To understand why these two stand out, let’s take a closer look at the field. On the surface all the various funds seem quite similar. But if you look closely, there are some large and even surprising differences.
Category 1: Total China market Funds
Names: BlackRock, State Street, Franklin Templeton, Vanguard
Since we’ve established that we want exposure to a large portion of the Chinese market due to compelling long-term trends, let’s look at some funds that give us broad-based access. Let’s cover a couple market structure basics first:
Exchanges: where do Chinese shares trade?
China-domiciled companies trade on a number of exchanges in different regions. Within Mainland China, we have A-shares which trade on the Shanghai and Shenzhen Stock exchanges. In Hong Kong we have H-shares. There are also a significant number of Chinese companies trading as ADRs on US exchanges. There are a handful of other share types and exchange locations, but this covers the majority.
Indices: what are the main indices that ETFs track and how are they constructed?
There are several large index providers that build and maintain the indices which many of the China ETFs track. The largest of which include MSCI, S&P, FTSE. They all tend to have a main index which includes most Chinese shares trading on all exchanges, an A-share index, and then other sub-indexes for large, mid and small cap, as well as other categories. The main index usually doesn’t include all companies, for example MSCI’s accounts for about 85% of total by market cap. And within the main index the A-shares are given a 20% weighting. So each index is a bit different, although the largest holdings tend to be similar.
Logistics: Restrictions on foreign investors in China
There are restrictions on foreign investors buying Mainland China-listed (A-shares) stocks. Institutional investors can apply for licenses to invest and are limited by quotas. Starting in 2014 for Shanghai and 2016 for Shenzhen, a stock connect program was opened up allowing foreigners to buy shares in certain companies on those exchanges via accounts in Hong Kong. Therefore, many of the total China indices only include A-shares which participate in the stock connect program. Additionally, there is 30% cap on foreign-ownership of any single mainland China listed company.
Ok, now let’s actually look at some ETFs!
BlackRock iShares MSCI China (MCHI)
The iShares MSCI China fund is the largest China ETF by AUM, with about USD 6.5 billion. It tracks the MSCI China Index, which targets large and mid cap companies across China A shares, H shares, foreign-listed (think Alibaba on NYSE etc.) and others. The Index itself contains 714 constituents while the iShares ETF contains 611. So this is a broad-based fund giving you exposure to a majority of Chinese publicly listed companies. It’s the largest China fund by AUM so liquidity won’t be a problem, and it is run by BlackRock so it should be managed well and safe for long-term holding.
What stands out to me most is the expense ratio of 0.59%, which seems high compared to many other index funds including iShares’ own S&P 500 fund (expenses of 10 bps), Vanguard’s S&P 500 (only 0.03%) and Vanguard’s global emerging markets fund (only 0.10%). As we will see, many of the broad-based China-focused ETFs charge fees above 50 bps, with more niche products charging above 70 bps.
Some other observations: Concentration of the Top 10 holdings is just under 50%, which you can see from the above comparison table, is typical of many China ETFs. For reference the top 10 stocks in the S&P 500 account for a little more than a quarter of that index, so China ETFs do tend to be a bit top-heavy. And similar to the S&P 500, Big Tech is dominant, making up a significant portion of the top 10-20 holdings of each ETF, with a handful of large banks and insurance companies sprinkled in.
State Street SPDR S&P China ETF (GXC)
Another broad-based fund, this time with the benchmark of S&P China BMI Index, which includes all publicly-traded companies domiciled in China which are available to foreign investors. As mentioned above, there are certain restrictions on which mainland China-listed companies can be purchased by foreign investors and how those investments can be made. This index is far larger than MSCI’s, with just over 2,000. 768 make it into the SPDR ETF, which is a bit more than iShares. The concentration is a bit lower than iShares at 43.5%. The expense ratio is the same at 59 bps.
Franklin FTSE China ETF (FLCH) [RECOMMEND]
What’s up with all these high fees? The Franklin FTSE China ETF only charges 19 bps. It tracks the FTSE China Capped Index, another broad-based index including Chinese companies listed in Mainland China, Hong Kong and around the world. The index has 1,019 constituents while the ETF has 842, giving it even broader exposure. Strangely, despite such an attractive price and no material differences in holdings and performance compared to iShares and SPDR, the Franklin fund has only attracted AUM of about USD 400 million (according to First Bridge Data as of Dec 4, 2020) albeit in a much shorter fund lifetime and growing quickly from just USD 60 million a couple months ago. If you are just looking to track the investable China market, FLCH gives you the lowest cost.
Vanguard Total China Index (Hong Kong: 3169)
Vanguard is closing its Hong Kong business and so this fund will be shut down over the next year or so. I include only because many people would be curious about what Vanguard’s offerings are/were in this area. This is/was their only China-focused ETF, the Vanguard Total China Index ETF. It trades only in Hong Kong, although can be bought in HKD, RMB or USD. It tracks the NAME index which has 1,284 constituents, and the ETF itself has 889 holdings, the most of any fund we examine. It is also the least concentrated, with the top 10 holdings accounting for just 36%. The expense ratio is 40 bps, lower than most other funds but still seems high considering this is Vanguard. By contrast, remember Vanguard’s emerging market ETF, of which China stocks account for 46% of total allocation, only charges 10 bps. Why does it cost 30 bps more to get the China component only?
Category 2: Thematic China ETFs
Now we come to some thematic funds. There is quite a variety, including Healthcare, Environment and others. But since China is home to some of the world’s most dynamic internet/communications/fintech players, we will just look at a few tech-focused funds. Anything more focused or esoteric could be considered later on after establishing a nice China foundation in our portfolio.
Invesco China Technology ETF - CQQQ
Let’s start with Invesco’s China Technology ETF. It includes the constituents of the FTSE China Index and FTSE China A Stock Connect Index that are classified as information technology securities. It holds 100 companies in total. If you take a look at the actual holdings, the first thing you might notice is that you won’t find Alibaba. Why? It is classified as Consumer Discretionary by FTSE as well as by other indices. For reference, Amazon is also classified as Consumer Discretionary and a quick scan shows that many other tech-focused ETFs include Amazon and/or Alibaba, and even Invesco’s own S&P 500 Tech ETF includes Amazon. I suppose you could just buy Alibaba separately, but I think many people would be surprised to find that the China tech ETF they just bought didn’t include one of the most dominant tech companies in China. Looking at some of the other top holdings in the fund, we see Alibaba’s peers such as Tencent (gaming, social media, mobile payments), Meituan (Yelp + Uber, why is this considered tech while Alibaba is not?), and other tech adjacent companies such as GDS (a real-estate company which builds data centers). So to me it is just logically inconsistent to not include Alibaba in this fund. That being said, it has done very well both this year and in the past 5 years (as have most tech funds both in China and globally). YTD it is up almost 50% and has averaged an annual return of almost 20% for the past five years, significantly higher than the broad-based total market ETFs.
KraneShares Internet ETF (KWEB)
KraneShares Internet ETF does give you Alibaba and all the other big China-domiciled internet companies. It is the largest thematic China ETF by AUM. It tracks the CSI Overseas China Internet Index and has just 32 holdings. Quite concentrated, the top 10 names account for about 63%. Like most other tech or internet focused funds, it has done very well as of late, up over 50% in 2020 YTD.
If you want to bet on the continued outperformance of big tech in China, you could consider this. But at the same time, you could probably pick a handful of the largest holdings and approximate the same performance without paying the 73 bps expense ratio. Also, this fund has no exposure to A-shares.
WisdomTree China ex-State-Owned Enterprises Fund (CXSE) [RECOMMEND]
State-Owned Enterprises (SOEs) are government-owned or controlled companies. People in western countries may not encounter or speak about them too often, but they are a large part of China’s economy and many of them are publicly listed. They tend to dominate industries which the government deems important to meeting basic social needs such as banking, energy and commodities. They often balance a number of priorities, including but not limited to profit. For example, a state-owned bank may make loans based on policy goals, not purely on the merits of the borrowers or the projects themselves. The WisdomTree China ex-SOE fund starts with the MSCI China Index and then filters out all of the SOEs (as defined by more than 20% ownership by China government), as well as excluding smaller A-share companies. What is left is about 150 companies, mostly in the tech and consumer spaces.
From WT’s literature, we see that during the 10 years to June 30, 2020, the non-SOE portfolio has performed the SOEs by 13.81% to 1.32% per annum. Over the five years through that same date, non-SOE outperformed SOE by 15.47% to -4.23%. SOEs tend to be over-represented in sectors such as banking, utilities, energy and other commodities. If one could say something in favor of owning SOEs, I suppose it would be that while not as likely to grow much, they are also less likely to fail do to government support (although recent defaults of some SOEs show that isn’t always the case either). Chinese bank stocks have done poorly due to over-leverage while oil companies have done poorly globally, perhaps they are due for a reversal of fortune at some point.
But CXSE’s results are hard to ignore. Since its inception in September 2012, it has outperformed the MSCI China Index 12.26% to 9.77% per annum. In the past 5 years, 22.57% vs 13.53%. And YTD it has returned more than 50%, putting it in the neighborhood of the China tech/internet thematic ETFs. And the expense ratio is 32 bps, much lower than the thematic ETFs and lower than all of the broad-based ETFs with exception of the Franklin fund. And at the same time we have much greater diversity than the sector-specific ETFs so face less risk of an individual sector falling out of favor or reverting to the mean. If there is one drawback with this fund, it may be the fact that it leaves out a lot of smaller A-share companies considering it only includes the 50 largest mainland listed companies that are a part of the above-mentioned stock connect program and which also meet index requirements. Overall it offers an attractive combination of expected performance and low cost.
So as a result of this exercise I’m buying FLCH to get total market exposure at low cost and CXSE to place additional emphasis on the more dynamic, non-SOE components of China’s economy.
