China’s $9 Trillion Untapped Market Spurs U.S. ETF Frenzy

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China Household Consumption
A woman browses clothing in the pedestrianized Dongmen area of Shenzhen. Household consumption in China climbed to 47 percent of gross domestic product last year from 43 percent in 2008, Morgan Stanley analysts wrote in a Nov. 6 report. Photographer: Brent Lewin/Bloomberg

The race is on to give U.S. exchange-traded fund investors access to $9 trillion of stocks and bonds in mainland China.

Money managers including BlackRock Inc. and CSOP Asset Management Ltd. have now registered almost 40 ETFs tracking the country’s domestic shares and debt with U.S. regulators, six times the number of existing funds. The products allow anyone with a U.S. brokerage account to gain exposure to Chinese securities that were previously off limits to all but a few qualified institutions.

Equities in the biggest emerging market are heading for the best annual gain since 2009, outpacing shares of mainland companies listed overseas amid speculation government plans to ease capital controls will narrow the valuation discount on domestic securities. As programs including a planned bourse link between Hong Kong and Shanghai help open up China’s markets, fund providers are rushing to stake claims to the fees they hope will come from new investors.

“There is so much potential, you just can’t ignore China,” Patricia Oey, a senior analyst at investment data provider Morningstar Inc. in Chicago, said in a telephone interview. Fund companies “want to have a foot into a very big market. China is opening up and they want to be there.”

BlackRock, CSOP

BlackRock, the world’s largest money manager, is seeking to introduce its first U.S. exchange-traded fund that would invest directly in equities traded in Shanghai and Shenzhen, according to a Sept. 15 regulatory filing. CSOP, which runs a $6 billion ETF of China’s yuan-denominated A shares out of Hong Kong, filed to create a U.S. version three days later.

Melissa Garville, a spokeswoman for BlackRock in New York, declined to comment on the ETF filing, as did a CSOP official who asked not to be named because of company policy.

While only a fraction of Chinese companies are listed or sell debt offshore, U.S. investors have piled almost $10 billion into ETFs that exclusively buy securities trading abroad, until recently one of the only ways for individuals to gain exposure to businesses from the world’s second-largest economy.

The Shanghai Composite Index has rallied 17 percent this year, compared with a 0.8 percent advance for a gauge of mainland shares listed in Hong Kong and a 4.1 percent gain for the most-actively traded Chinese stocks in the U.S.

Trading Link

The success of the $457 million Deutsche X-trackers Harvest CSI 300 China A-Shares ETF, which has lured more money than any other China-focused ETF since it was launched a year ago, reflects growing investor demand for Chinese companies linked to the nation’s expanding consumer market.

The CSI 300 has a weighting of about 18 percent in consumer-related companies, versus 5 percent for the Hang Seng China Enterprises index of Hong Kong-listed shares. Household consumption in China climbed to 47 percent of gross domestic product last year from 43 percent in 2008, Morgan Stanley analysts wrote in a Nov. 6 report.

“The composition of Chinese GDP growth has changed dramatically over the last three to five years,” Dodd Kittsley, the New York-based global head of ETF national accounts and strategy at Deutsche Bank AG’s Deutsche Asset & Wealth Management unit, said in a telephone interview.

The exchange link between Hong Kong and Shanghai will debut on Nov. 17, regulators said in a joint statement today. The program permits international money managers to purchase a net 13 billion yuan ($2.1 billion) a day of Chinese shares, while also providing a route for mainland investors to buy Hong Kong equities.

MSCI Benchmarks

Speculation that relaxed capital controls will entice index providers including MSCI Inc. to incorporate China’s local shares into global gauges is also attracting investors.

About $9 trillion is benchmarked against MSCI indexes globally, according to the company’s website, including more than $1 trillion to its emerging-market index. China could comprise between 30 and 50 percent of the developing-nation gauge in the next decade if domestic securities are added, up from less than 20 percent now, according to Brendan Ahern, managing director at Krane Fund Advisors LLC, which oversees three Chinese ETFs.

“You have a continued opening up that’s accelerating,” Ahern said by phone. “China wants to see their markets become more institutionalized, and foreigners help in that process.”

Krane and E Fund Management (Hong Kong) Co. are set to introduce the China Commercial Paper ETF later this month, giving international investors access to one of the shortest-maturity portions of the country’s bond market, the third-largest worldwide.

Rated Debt

The average yield on AA rated debt in China due in about 90 days is 4.31 percent, according to data compiled by ChinaBond. By contrast, non-financial commercial paper of that maturity with similar ratings in the U.S. pays 0.09 percent, according to the Federal Reserve’s website.

The ETF will start with about $330 million of government approved quota, according to David Zhang, chief investment officer at E Fund HK.

Money managers who register new ETFs with the U.S. Securities and Exchange Commission still face several hurdles before the funds can start trading. There are over 1,000 ETFs currently filed with U.S. regulators, according to data compiled by ETF.com, including many that’ll never make it to market.

In addition to SEC approval, ETF managers who buy China’s domestic securities need a Renminbi Qualified Foreign Institutional Investor license, known as an RQFII. They also need to submit an application to China’s State Administration of Foreign Exchange for an investment quota. Gaining access to certain domestic fixed-income markets also requires approval from China’s central bank.

The lengthy process explains why so many ETF providers are looking to get potential funds registered early, Ahern said.

‘Unique Exposures’

There are about twice as many filings for ETFs that would invest in China’s onshore stocks and bonds than there are for funds seeking to trade only overseas-listed securities, according to data compiled by Bloomberg.

“Providers have recognized an opportunity,” Chris Hempstead, the head of ETF sales at KCG Holdings Inc. in Jersey City, New Jersey, said by phone. “The existing products offering exposure to China A-shares are still relatively new, and the products in the pipeline are likely to offer unique exposures of their own.”

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