China ETF race heats up

Barclays Global Investors will launch an exchange-traded fund based on China A shares next week in Hong Kong, making it the first to provide the non-mainland domestic retail investment base access to that market.

The move comes just before Beijing-based China Asset Management and its partner State Street Global Advisors launches China's first domestic, renminbi-denominated ETF based on a Shanghai Stock Exchange index.

Due to the complicated nature of China's underdeveloped capital market, both the international and the domestic versions face unique challenges. Both BGI and SSgA are confident that they have found ways around these problems. If so it will be interesting to see which firm hit on the more lucrative strategy.

All things being even, in the short term at least, the big difference could turn out to be investor sentiment: to what extent do foreign investors want to access the rather pricey A-share market, and how much confidence do local investors have for a perpetually disappointing stock market?

The iShares FTSE/Xinhua A50 China Tracker will debut on the Hong Kong Stock Exchange on November 18, based on an index that captures the top-50 A shares trading on the Shanghai and Shenzhen bourses. Although BGI will market this to global investors, the small minimum investment of one board lot of 100 units should cost around HK$4-5,000 at launch, making it affordable to retail investors as well. As the ETF will be listed in Hong Kong, investors can buy it from brokers.

For BGI this fills out a stable of China ETFs; the firm already offers ETFs based on red chips, H shares and B shares. Joseph Ho, regional director for North Asia at BGI, says the total China stock market capitalization is about $600 billion, including all share classes, making the market bigger than Taiwan or Korea. The A-share market comprises 69% of that total market cap, and the FTSE/Xinhua A50 offers a more diverse range of companies than found in the H-share or red chip market.

Ho says the ETF should appeal to global investors struggling to invest into the mainland market. Currently only qualified foreign institutional investors (QFIIs) can invest directly into A shares. This is expensive and requires a lot of capital, and to date there are only two institutional funds dedicated to A shares (managed by Martin Currie and Singapore-based APS Asset Management). Some institutions have also been able to access the QFII market through structured products such as derivatives and guaranteed funds, but many institutions are restricted from this type of investment, or are put off by the high cost or having their money tied up, Ho argues.

The A50 China Tracker will track the performance of FTSE/Xinhua's underlying index, subject to currency rate fluctuations, but capital controls mean BGI cannot own the underlying shares, as it would in other markets. It has teamed with Citigroup Global Markets, which has a QFII license and will issue Chinese A-Shares Access Products (CAAPS), a type of warrant, to replicate the economic interests of the underlying investment.

Citigroup Global Markets will also serve as the market maker, while HSBC Institutional Trust Services has been appointed trustee and registrar. Simmons & Simmons served as legal advisor.

In its role as market maker, Citi will be encouraged by the creation and redemption process to encourage it to buy or sell the ETF, says Justin Kennedy, managing director for equity derivatives in Asia Pacific. "If the ETF starts trading at a meaningful discount, then we will be naturally incentivized to buy at such a discount and redeem at NAV, and if it trades at a meaningful premium we will be incentivized to sell at such a premium and create units to cover."

The fund will be open ended and should therefore not suffer from a material premium or discount, he adds - unless either Citigroup runs out of its QFII quota, or if China's regulators restrict Citigroup from expatriating QFII funds from China, which would prevent it from redeeming.

Citi's QFII quota is $400 million and it has pledged a minimum of $50 million to be available over the next 12 months for the ETF. "Yes there are restrictions on repatriation," says Kennedy, "but at present, demand for our QFII quota is so great that we can always find a productive use for idle QFII money, so the repatriation restrictions are largely academic."

The management fee is quite high for an ETF, however - 99 basis points. BGI's Ho says this reflects the high trustee and custody fees in Hong Kong, as well as the fact that it lacks the scale of huge ETFs such as the Hong Kong Tracker Fund, managed by SSgA.

Some industry observers think, however, that the Hong Kong custody and admin fees for an ETF should not be so high, and that perhaps most of the cost is due swap contracts with Citi. BGI's other China ETFs also charge 99bps, however.

Meanwhile, China Asset Management and SSgA expect to launch their domestic ETF by Chinese New Year and hope to get final approval from China's government this month, says Vincent Duhamel, CEO at SSgA in Hong Kong.

Designed for domestic institutional and retail investors, the China Tracker Fund will track the Shanghai bourse's SHSE50 Index of the biggest stocks by market cap. The fund managers have high hopes that the government will use it to gradually sell down its ownership of listed state-owned enterprises, akin to the Hong Kong government's use of the Tracker Fund in 1998.

While the BGI version for global investors must face the complications of QFII, the ChinaAMC/SSgA domestic version comes with its own complications. Without a domestic futures market, hedging tools or ability to short stocks, the mechanisms are missing to keep the ETF's NAV in line with those of the underlying stocks. (This is not an issue for the BGI version, which is listed in Hong Kong where plenty of such tools exist.)

Another risk, according to some market players, is that investors could be caught naked during the process of creating or redeeming shares, because without proper market hedging tools, they are totally exposed to any market fluctuations for as long as two days.

Duhamel says the lack of a futures market is a problem but not a deal-killer, because even without a futures market, participants can still create or redeem ETF units. There will be discounts or premiums higher than found on, say, the Hong Kong Tracker Fund, which can vary by 30bps because of stamp duties and transaction costs. But Duhamel rejects the notion that such variations will be as high as those for China's listed closed-end mutual funds, where NAVs can get as far as 40% out of whack. Rather, he thinks the China ETF's NAV discrepancies will be in the order of 1.0-1.5%. "This reflects the inefficiency of not having a futures market, but arbitrageurs can still operate in the cash market," he says.

The inability to short remains an issue, because it makes arbitrage complicated, but no one is going to look for this without a futures market, making it a non-issue, Duhamel says. What will be more important is educating mainland brokers about ETFs so they play their natural arbitrage role.

He expects total fees to be around 50bps, about a third cheaper than domestic equity mutual funds.

SSgA's next goal is to cross-list the China Tracker Fund in other markets, which will require approval from the China Securities Regulatory Commission.