China ETF

What Is a China ETF?

A China ETF is an exchange-traded fund (ETF) that invests in Chinese securities. These funds are generally passive, meaning they mirror the holdings of an underlying index such as the MSCI China Index or the FTSE China Indexes.

Two national stock exchanges are operating in China: the Shanghai Stock Exchange and the Shenzhen Stock Exchange. In addition, many mainland Chinese companies list shares on the Hong Kong Stock Exchange. China ETFs can invest in a wide number of Chinese securities, including A Shares, B Shares, H Shares, and Red Chips, in addition to American depository receipts (ADRs) of Chinese companies.

Understanding a China ETF

Investors keen on China have four main options. One is to invest directly in companies listed on the Shanghai or Shenzhen stock exchanges, which is difficult to do unless you are Qualified Foreign Institutional Investor. A second option would be to open a brokerage account in Hong Kong, which would give you access to mainland Chinese companies listed in the city. Alternatively, investors could buy the global depositary receipts or ADRs of Chinese companies. Finally, another avenue is to target U.S. companies that are growing their business in China.

Adding Chinese stocks to your portfolio would provide exposure to a fast-growing economy, as well as a cushion against losses should economic growth slow in other parts of the world. However, stock picking in this country isn't a strategy suited to most. The Chinese market can be very volatile. The opacity of financial information, not to mention a lack of veracity, makes it difficult to evaluate individual companies. Investors hoping to tap into China are usually better off spreading their bets.

This is where China ETFs come in. There's quite a bit of choice. ETF Database listed 46 China ETFs as of January 2021. The largest of these were the iShares MSCI China ETF (MCHI) and the iShares China Large-Cap ETF (FXI). Many funds track the country's biggest companies. Others hone in on specific sectors and themes such as the internet, formerly state-owned enterprises, consumer discretionary, financials, and small-caps.

Benefits of a China ETF

China is an investment opportunity that few want to pass up. The country has shaken off the effects of the COVID-19 pandemic better than most. The International Monetary Fund expects that China will grow its economy by 8.1% in 2021.

The IMF expects the Chinese economy to grow by more than 8% in 2021.

ETFs offer perhaps the easiest way to tap into this growth engine without worrying about legal and tax implications and individual company setbacks. ETFs are bought and sold on a national exchange and trade like stocks. Management fees are typically lower than mutual funds. ETFs can also provide diversification in markets fraught with risk and unknowns to the average investor.

Criticisms of China ETFs

Investing in China isn't without drawbacks. The country is led by a single political party that gooses GDP figures by spending on questionable infrastructure projects. Obtaining solid and accurate information about Chinese public companies is also difficult.

Volatility or swings in price can be an issue. It's not unusual to see benchmark indices swing as much as 10 percent within a day. Pundits blame this on retail investors, who have few outlets for their savings and account for a significant portion of domestic turnover. Domestic fund managers are also fairly impatient and prone to emphasizing short-term performance.

Another major issue is the level of diversification China ETFs offer since some China ETFs could be heavily weighted toward financial, construction, and telecommunications companies. However, a lack of diversification can be an issue with any ETF. The iShares MSCI China ETF (MCHI) and the iShares China Large-Cap ETF (FXI) are fairly-well diversified by investing in consumer discretionary, financials, healthcare, as well as communications as their top holdings by industry. As a result, investors need to research the holdings to determine their level of diversification.

Special Considerations

At present, there are two pressing issues weighing on Chinese bourses and ETFs.

U.S.-China Trade War

For many ETFs, the fallout from the U.S.-China trade war has been disastrous. The two global powerhouses have imposed tit-for-tat tariffs on hundreds of billions of dollars of each other's goods. In January 2020, a truce was reached and a preliminary deal signed, much to the relief of investors. However, some of the trickiest, most delicate issues still remain unresolved.

Delisting of Chinese ADRs

On December 2, 2020, the House of Representatives passed the Holding Foreign Companies Accountable Act, which was approved by the Senate in May 2020. The bill would bar Chinese companies from listing shares on U.S. exchanges unless they allow the Public Company Accounting Oversight Board to audit their financial records. If the bill is signed into law, Chinese companies would have three years to comply before their shares are delisted.

Separately, on November 12, 2020, former President Donald Trump signed an executive order that prohibited U.S. investors from holding shares of companies that are owned or controlled by the Chinese military. The order prohibited the purchase of companies with Chinese military links beginning on January 11, 2021. Investors have until November 11, 2021, to divest any existing holdings.

In response, S&P Dow Jones Indices said it would remove 10 companies from its indices, including shares of contract chipmaker Semiconductor Manufacturing International Corp (SMICY). FTSE Russell has removed multiple Chinese companies from its indices.

China Telecom (CHA) told investors the executive order might impact the trading prices of its ADRs. Its shares shed more than 20% of their value following the announcement of the executive order. Although Trump lost his reelection campaign, President Biden has yet to rule on how he plans on handling China and whether the tariffs or Trump's executive orders will remain in place.