Zaks Investment Advisory Service

Chinese ETFs and China’s Prospects

I devoted the three previous programs to China. Last time, we talked about financial instruments that could allow American investors to buy Chinese company shares. I said that investors could buy Chinese stocks directly by purchasing so-called ADRs, or American Depository Receipts, or do so through investment funds: mutual funds and closed-end funds.

All of these financial instruments allow investors to participate in the Chinese markets, but each one of them has drawbacks. Individual shares are too risky for most investors. Mutual funds are often very expensive. Some of the closed-end funds are quite interesting, but there are relatively few of them. Moreover, investors must understand the paradox of closed-end funds: sometimes their prices are quoted above their per-share net asset value (NAV), i.e. they trade at a premium, and sometimes they trade below that net asset value – i.e. at a discount. For example, a closed-end fund that is simply called the China Fund was quoted at 20 percent above its net asset value at the start of January of 2006, and now trades at 15 percent below its NAV. The China Fund mostly invests in companies whose shares are traded on the Hong Kong exchange. Its shareholders have little to complain about: since the start of 2006, this market has gained more than 80 percent. So even while failing to see as large a return as the index itself, a China Fund shareholder still made a profit. Nevertheless, it is essential to remember the particular character of closed-end funds. By the way, we devoted an entire program to the closed-end fund paradox. You may read it here.

There is a class of financial instruments that resembles closed-end funds, but which is quoted at very-near NAV thanks to the specific nature of its construction. These instruments are called exchange-traded funds (ETFs). We talked about them several weeks ago. You may read about them here. Simply as a reminder: ETFs are index, passively managed funds, whose shares are traded on the US exchanges. A “passively managed” fund means that its managers construct the fund according to the corresponding index. In this, it differs from an actively managed fund: here, managers try to pick stocks they think will have superior performance. As you probably know, I am pretty skeptical of the idea that managers are actually able to find such stocks, and, most importantly, to do so consistently. An analysis of the performance of active funds compared to that of indexes as a whole confirms my skepticism. Active fund managers demand compensation for their work, which usually makes actively managed funds significantly more expensive than passively managed ones. ETFs, which appeared on the market a relatively short time ago, are probably the most efficient passive instrument that investors have access to.

There are several Chinese ETFs. They differ from each other mostly by which index they follow. Almost all of the indexes are comprised of Class B shares (we talked about how Class B shares are quoted in US or Hong Kong dollars and are accessible to foreign, including American, investors). For example, one of the ETFs is compiled according to the FTSE/Xinhua China Index (i.e., an index that was put together by the Financial Times Stock Exchange and the Chinese Xinhua news agency), and another ETF follows an index compiled by S&P and Citigroup. There are also ETFs that correspond to the Hong Kong stock exchange. All of these ETFs have low expense ratios, and are quoted at near the net asset value of the funds themselves.

Over the past two years, Chinese stocks were one of the best performers in the world. For example, during that period, Class B shares gained an absolutely surreal 500 percent, i.e. they grew by a factor of six. Class A shares gained 380 percent. Hong Kong shares went up by almost 100 percent, i.e. they doubled in two years. And we are not talking about individual companies – sometimes, specific companies grow very fast, if one only recalls the example of Google. But here, we are talking about the entire market! For comparison: the S&P 500 index gained about 20 percent in this time. Twenty percent over two years, plus another three percent or so for dividends, is not such a terrible return for us – it is certainly better than a CD. But this, of course, is simply incomparable to what was happening on the Chinese markets.

Can Chinese markets continue to grow just as fast in the future? Of course not. Moreover, we must remember that in not so distant past there was a period of several years during which Chinese shares not only failed to grow, but actually lost value. And as I have already said on several occasions, both the Chinese economy and its financial system are experiencing numerous problems. Many of the Chinese state companies are inefficient, having bloated staff and practically living at the government’s expense. The Chinese economy as a whole largely depends on exports. If our own economy falls into recession, this will have a big effect on the Chinese economy. I would also like to remind you that the Chinese financial system is a long way off perfection. It will require many more years before it reaches the level of developed nations. Nevertheless, the Chinese economy is growing at an annual rate of 10-12 percent, faster than any other major economy in the world. China’s potential is huge. We should harbor few doubts that at one stage, the Chinese economy will stall and fall into crisis: this happened in both Taiwan and South Korea, which also, as we all remember, grew very rapidly over a long period of time. How China overcomes its eventual crisis will determine not only the future of China’s economy, but also that of the entire world. All of these factors make Chinese shares fairly risky. Nevertheless, for people investing over the long term, Chinese shares represent a very interesting opportunity in terms of portfolio diversification.

With this, we will have to draw today’s program to an end. In our next program, we will talk about other developing nations. This was Sergey Zaks. Thank you for your attention and until next time.