Tracking China

Do you want to be in on the China stock craze? However unwise that might seem, if you are outside China it is even crazier. For foreigners this is a game that only the investment banks seem to win. For the individuals and hedge funds that play, it looks like zero-sum.

The simplest way of following a stock market is either to buy/sell futures or via an exchange traded fund (a fund that tracks an index, but can be traded like a stock). There is no Shanghai stock futures market and even if there were it would not be open to foreigners. So what about an ETF? There are supposedly a few of those traded outside China that investors might fondly believe mirror China stocks.

But just look. The most alarming case is that of the Hong Kong-traded I-Shares A50 China Tracker fund, which is supposed to track the FTSE-Xinhua index of the top 50 mainland companies. The index has done monstrously well, rising even more dramatically than the broader and more often quoted Shanghai Stock Exchange Index. Clearly it has been the place to be and for foreigners to be there via the ETF, listed as on the Hong Kong bourse.

The fund is managed by Barclays Global Investors, which runs all the various I-shares, a species of ETF. The market-maker is Citigroup, which is supposed to trade the underlying stocks in order to keep the market price of the ETF in line with the value of its component stocks. That indeed is the main point of an ETF and is supposed to distinguish it from a closed-end fund whose price can, and usually does, diverge from its underlying net asset value depending on market sentiment.

But I-Shares China has in effect been behaving more like a closed-end fund than an ETF. In the early days of the current China mania, which only began around October last year, foreign demand for the ETF was strong and the price went to a premium over the net asset value. At one time the premium exceeded 20 percent. This was handy for Citi which was able to sell shares at a premium to the price it was paying for the underlying stock.

More recently foreigners, listening to Alan Greenspan and other soothsayers, have got nervous about China and been anxious to unload their ETF. There haven’t been too many foreign buyers around so Citi has been able to sit around and pick up stock at well below asset value before selling the underlying stock into the A share market. More easy profits.

Given that the A share market is only open to a few foreign institutions, market making is more difficult than for other ETFs so some inefficiencies are to be expected and some profits accrue to those able to arbitrage the two. But the way the funds are set up appears to make it particularly easy for the market maker to reap large profits by exploiting the shifts in foreign investor sentiment relative to sentiment in China itself.

Nor is there much option. Morgan Stanley also has a China A tracker fund listed in New York. But this is a closed-end fund which has seen big swings in its price relationship to NAV. It now trades at a discount of 20 percent so its performance over the past six months has seen a gain of 65 percent compared with more than 100 percent for the A50. index. This gap is also partly due to the fact that only 80 percent of its assets need be in A shares. It can invest the rest in Hong Kong and other foreign listings of China stocks.

There are other funds that investors may believe track China but do not track the China market itself, rather China via Hong Kong listed H shares and Red Chips. These have risen only very modestly by comparison. Take for example the I-Shares New York listed FTSE Xinhua China 25, which has risen some 30 percent since last October compared with a 110 percent gain by the A50 China Tracker. Its trade price has stayed close to its asset value but that fact and the relatively poor index performance reflects the fact that is a vehicle for Hong Kong listed shares, the portfolio being dominated by the likes of Petrochina, China Mobile, China Life and ICBC. Similarly the I-Shares MSCI China Tracker which is traded in Hong Kong is invested in Hong Kong-listed stocks and its price sticks close to asset value.