The right kind of China ETF

Aug 9th, 2013 | By | Category: Equities

By David Stevenson

This week I’m going to carry on banging my contrarian drum with a call to action focused on Chinese equities. Although I wouldn’t quite come out and say that now is the right time to buy into China ETFs, I do think that astute investors should start to think long and hard about intelligent ways to buy into the right bits of the Chinese story. And the good news is that there’s a growing number of smart ETFs offering exactly the right kind of exposures. More on that in a moment.

The right kind of China ETFs

The consumer sectors are one area of the Chinese market that offers huge promise as the authorities there attempt to boost domestic consumer demand.

But first, to say that my (cautious) enthusiasm for Chinese equities is a contrarian view is, I think, rather understating matters – the latest reading of the Citywire db X-trackers Emerging Market Sentiment Indicator shows that! The bitter truth is that most western investors have been on a real downer about China for many months now. This revulsion against China takes on many forms. Some of it is grounded in bitter, practical reality – having lost money in spivvy western-quoted Chinese stocks, investors are sensibly über-cautious.

Some of the backlash is also based on indisputable, sensible prejudice i.e. that the Chinese Communist Party is too strong and corporate governance too weak. But most of the scepticism is more short to medium term in nature and based around a simple fear of slowing growth – and the side effects of a radical transformation of the Chinese economy. The bears argue that this slowing down merely reveals China to be the next great financial crisis.

At this point in the discussion any investor who’s bothered to take the time to follow the brilliant blogs of Beijing-based American economist Michael Pettis will probably shrug and say “I told you so”. Michael is one of many astute Sino observers who’ve consistently warned that we underestimate the challenges facing the world’s next great superpower. In fact, there’s a very long line of China bears (notably hedge fund investors such as Eclectica’s Hugh Hendry) who’ve maintained that China is the next credit bubble waiting to burst – the next great Minsky moment.

The legendary equity bear, strategist Albert Edwards over at French investment bank Societe Generale is another of those sceptics. He’s long argued that Chinese equity markets are a classic example of fool’s gold – growth markets promising amazing riches but likely only to impoverish the poor investor! His bearish analysis has also found an echo in the work of his colleagues who are focused on Chinese research – economists such as Wei Yao have been consistently cautious about prospects for the economy. In a recent paper entitled ‘What if China lands hard?’, this band of SocGen economists and strategists have at long last spelt out exactly how bad they think it could get in China – and what that means for the global commodities sector.

According to the SocGen analysts, “Our core scenario is that China will see a bumpy landing over the medium term, with growth grinding persistently lower from 7.4% in 2013 to 6% in 2017. However, there is still a non-negligible risk that China could land hard, with growth of less than 6% in 2013”. Clearly if these numbers are right then Chinese equities are in for a nasty few years whilst the whole commodities space could sink into oblivion!

But I have my doubts about this worst-case analysis. Recent data suggests that the economy is finally turning the corner – in fact local stocks were up sharply at the start of the week as China’s economy started to show signs of stabilizing. The non-manufacturing sector PMI numbers, for instance, rose to 54.1 in July from 53.9 in June, while a services index from HSBC and Markit Economics was unchanged at 51.3 (readings above 50 indicate expansion). Remember that the services sector now holds at least 45% of GDP, if not more – with e-commerce and gaming not even included in this measure.

These recent numbers suggest that now may be the exact right time to get ahead of the curve and investigate new ways of accessing the Chinese equity story – and a newbie ETF specialist KraneShares seems to be ready to take up the challenge. Over the last few weeks this China-focused asset manager has launched two new ETFs on the Nasdaq Stock Market that deserve attention.

The easiest ETF to explain is the firm’s KraneShares CSI China Internet ETF (KWEB), which is a new fund that provides exposure to Chinese internet and internet-related companies. According to Brendan Ahern, Managing Director of KraneShares, “we see two powerful demographic trends driving China’s internet sector: since 2000, internet spending by urban Chinese has increased 14% annually, and China’s rural population continues to migrate to urban areas, further fueling internet usage.”  Ahern points to a McKinsey & Company report that stated China E-Tailing accounted for $190 billion in sales in 2012 and could reach as much as $650 billion by 2020. Apparently there are already 600 million internet users in Mainland China and according to the index designers behind the ETF, China Securities Index Co, “Chinese internet company market capitalizations now rival the largest US and global industry leaders, along with the potential for Chinese internet IPOs to come later this year”.

My own personal favourite is the KraneShares CSI China Five Year Plan ETF (KFYP) which invests in publicly traded China-based companies whose primary business or businesses will be important in the Chinese government’s current Five-Year Plan. In practical terms that means information technology companies (35%), consumer discretionary outfits (16%), and industrials.

With both funds, KraneShares is trying to move the debate on from “buy Chinese equities” to “buy the right kind of Chinese equities”. This is an important shift and reflects the reality that not all companies on the local exchanges are going to prosper in the new China. Arguably a good active fund manager should be able to spot the winners and losers but the evidence suggests otherwise – the vast majority of active fund Western-based managers consistently get local stock picking wrong. Yet the opposing strategy of simply buying the aggregate index or a big sector through an ETF also seems to be a little suspect in my view. The KraneShares ETFs represent a middle ground – a focused index strategy using certain key sectors but within a relatively low cost ETF. Hopefully more competitors will emerge in the next few months and years – including over here in Europe – offering up many more intelligent ways to play the China story.

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2 Comments to “The right kind of China ETF”

  1. Nick says:

    I’ve been in QQQC since 16.41 and I also believe there is room for growth especially in the china technology sector. 21st century westernization is what I like to call it.

  2. Simon Smith, CFA says:

    The Global X Nasdaq China Technology ETF (QQQC) is a great ETF, although very small. We’re going to keep an eye on how this fund performs relative to KraneShares’ new China internet ETF. I guess the main difference between the two funds, in terms of significant constituent weights, is Lenovo. But they’re both interesting funds. I think David Stevenson is absolutely spot on, though, when he talks about the need to move beyond “buy Chinese equities” to “buy the right kind of Chinese equities”. The China story has a long way to go – but you need to play it intelligently.

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