Playing China’s Investing Frontier; The move by China to open its local stock markets is triggering a new wave of ETFs

Playing China’s Investing Frontier

The move by China to open its local stock markets is triggering a new wave of ETFs.

MURRAY COLEMAN

Nov. 15, 2013 6:28 p.m. ET

The $1.2 trillion stock market in mainland China—home to the world’s second-largest economy—is opening up even more to foreign investors, but hazards still abound. The Deutsche Bank‘s DBK.XE -0.35% db X-trackers Harvest CSI 300 Index ETF,ASHR +4.36% the first U.S.-listed exchange-traded fund to invest directly in China’s A-shares, began trading on the New York Stock Exchange on Nov. 6. A-shares, which trade on the Shanghai and Shenzhen exchanges, have been largely closed off to foreign investors.The db X-trackers ETF charges fees of 1.08%, or $108 per $10,000 invested. Like most stock ETFs, it tracks an underlying index and trades throughout the day on an exchange.

More options are on the way. At least two other fund companies, Van Eck Associates and KraneShares, are planning to either start new funds to buy and sell A-shares directly or use existing funds to do so.

“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.

Until recently, most offshore investors have had to invest in China through companies listing overseas, mainly in H-shares traded in Hong Kong. The only way such investors could buy directly in mainland China’s market was through B-shares, which are denominated in foreign dollars. A-shares, which are traded in Chinese yuan, also called renminbi, represent a much broader array of companies.

Large banks and asset managers have been able to apply to get access to the more popular A-shares, but many of them complained that asset requirements and other demands were overly restrictive.

Relaxed Standards

Now, many of those standards have been relaxed, letting more foreign players qualify to tap into a local market with more than 2,000 different stocks. In the past year, the number of large asset managers and banks allowed to trade directly in China’s A-shares has nearly doubled to 237, says Chin-Ping Chia, an analyst at index provider MSCI based in Hong Kong.

Such investors generally are allowed to buy up to about 30% of a company’s A-shares, says Nizam Hamid, a senior research consultant at index provider FTSE Group in London.

A-shares have often commanded a steep premium compared with shares of China companies traded in Hong Kong and elsewhere. But as the market has opened to more foreign trade, such pricing anomalies have largely disappeared, says Burton Malkiel, an economics professor at Princeton University and chief investment officer at online adviser Wealthfront in Palo Alto, Calif., which has more than $400 million in assets.

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

Even so, some advisers caution against rushing into funds focusing on A-shares, since many of those companies are relatively small and have proved highly volatile. They say it doesn’t help that the financial statements of many Chinese companies are notoriously untrustworthy.

Another potential problem: Beijing could curtail access to A-shares at any time, says Michael McClary, chief investment officer at ValMark Advisers in Akron, Ohio, which has some $4 billion in ETF assets. “That could inflate prices and make ETFs more difficult to trade,” he says.

Despite those issues, Mr. McClary notes that both MSCI and FTSE Group have put A-shares on separate watch lists for possible inclusion into broader emerging-market benchmarks.

For example, China’s chunk of the FTSE Emerging Markets Index would rise to about 24% from a slightly less than 20% stake if A-shares are included with current ownership limits, Mr. Hamid says. Without restraints on ownership, that would swell to about a third of the benchmark’s composition.

The Need to Be Wary

But while greater access to foreign capital should boost asset values over time, investors still need to be wary, says Chris Konstantinos, director of international equities at RiverFront Investment Group in Richmond, Va., which manages $3.9 billion.

The firm’s portfolio managers say they are content to invest in China broadly through funds that don’t hold A-shares. One current favorite is the iShares MSCI All Country Asia ex-Japan AAXJ +2.17% ETF, which charges fees of 0.67%. Its top country is China, at 24% of assets.

Mr. Konstantinos is advising U.S. investors against being in a hurry to buy into the new crop of ETFs—or to use mutual funds that invest in mainland Chinese 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.