Advisers Wary of New Crop of China ETFs; Advisers find reasons to be on guard about A shares

Advisers Wary of New Crop of China ETFs

Advisers find reasons to be on guard about A shares

MURRAY COLEMAN

Nov. 13, 2013 9:11 a.m. ET

The trickle of funds investing in China’s $1.2 trillion mainland stock market is starting to arrive, promising to redraw maps across emerging markets for foreign investors. Last week saw the debut of the first U.S.-listed exchange-traded fund to invest in so-called “A” shares from the world’s second-biggest economy. The launch of DeutscheDBK.XE -0.90% Asset & Wealth Management’s db X-trackers Harvest CSI 300 Index ETFASHR -1.51% (ASHR), with $108 million in seed money, marked the biggest initial capital investment for an equity ETF since 2007.More are on the way. At least two other fund providers are making plans to either convert existing stock portfolios to A shares–rather than using derivatives to simulate direct exposure–or to come out with new offerings.

“There are still hurdles to overcome, but as it stands now, these new ETFs are going to be the best way for U.S. investors to access a big and fairly closed-off market,” says Dennis Hudachek, an analyst at market researcher IndexUniverse in San Francisco.

Still, some advisers caution against rushing into any new funds trying to tap into more than 2,000 different Chinese companies that have largely been off-limits until recently to most foreign investors.

The concern is that A shares can be volatile, just like the Shanghai and Shenzhen exchanges themselves. Portfolio managers also point out that the financial books of many Chinese companies are notoriously untrustworthy and that Beijing could curtail access to A shares at anytime.

In the past year nevertheless, as Chinese authorities have loosened restrictions, the number of large asset managers and banks gaining qualified status to trade directly in China’s A shares has nearly doubled to about 237, says Chin-Ping Chia, a Hong Kong-based analyst at index provider MSCI Inc. MSCI +0.36% (MSCI).

Those granted status to make such deals are given quotas, which Mr. Chia estimates in total add up to about 5% of A shares’ float-adjusted market capitalization.

“Still, foreigners are able to access, on a limited basis, all of the local companies in China,” he says.

If the new ETFs prove a hit, and active mutual-fund managers start turning to A shares, some advisers fear that U.S. investors could face a halt in new shares being created or a return to riskier derivatives contracts to capture exposure.

“Over the past year, China’s regulators have been pretty good about increasing quotas for foreign managers–but it’s early in the game and that situation could change quickly,” says Tyler Denholm, a portfolio manager at ValMark Advisers in Akron, Ohio, with about $4 billion in ETF assets.

Even though he remains wary of such risks, Mr. Denholm believes that China’s A shares is a market that U.S. investors need to start watching more closely. Both MSCI and rival FTSE Group have put China A shares on separate watch lists for possible inclusion into broader emerging-markets benchmarks, Mr. Denholm points out.

In the FTSE Emerging Markets Index, for example, China’s slightly less than 20% stake would go up to about 24% if A shares were included at current quota levels, estimates Nizam Hamid, FTSE Group’s senior research consultant in London. Without quotas, that number would swell to about a third of the benchmark’s composition.

It’s probably worth noting that such shares have been on FTSE’s watch list since 2005. One sticking point, says Mr. Hamid, is that even after fund managers receive official approval, they must invest their full quotas within six months. Also, many funds can only sell a certain amount of A shares per week, he adds.

“What’s important to us isn’t the amount of the quota, it’s more about the restraints put on that capital,” Mr. Hamid says.

In such a restricted market, A shares have often commanded a steep premium compared with shares of China companies traded in Hong Kong and elsewhere.

As the A shares market has been opened to more foreign trade, such pricing anomalies have largely dissipated, says Burton Malkiel, an economics professor at Princeton University and chief investment officer at online adviser Wealthfront Inc. in Palo Alto, Calif., with more than $400 million in assets.

“It’s a mistake to look at A shares through a rear view mirror,” he says. “The market has changed.”

While greater access to foreign capital should prove a net positive over time, investors still need to be aware of just how much of an opening they’re really being offered in China, says Chris Konstantinos, director of international equities at RiverFront Investment Group in Richmond, Va., with $3.9 billion in assets.

“The Shanghai market has been viewed by some as a dumping ground for politically connected business leaders to monetize their stakes at the expense of the individual Chinese investor,” he says.

Mr. Konstantinos is advising U.S. investors against being in a hurry to buy into the new crop of ETFs–or to embrace mutual fund managers who take a bigger shine to directly investing in mainland companies.

“We’re waiting to see China’s veil drawn back a little more before recommending to anyone that it’s time to jump into funds loading up on A shares,” he says.