Photographer: Tomohiro Ohsumi/Bloomberg

Using ETFs to Predict Where Chinese Shares Will Open Can Be Tricky Business

Nothing is as it seems.

Looks can be deceiving when it comes to using U.S.-listed China exchange-traded funds to determine where Chinese stocks will open.

Investors are learning this the hard way, following a volatile start to the Western new year in Chinese stocks. While ETFs have become a go-to way of finding out what investors think of international markets that are closed during U.S. hours, there is more than meets the eye in the case of mainland China when it comes to using the funds to determine where stocks will open.

Not only is China’s domestic market almost entirely owned by local investors—which can make it less predictable than markets with a greater proportion of foreign ownership—but it is also very much subject to actions taken by the Chinese government. Throw in whatever happens in U.S. markets while China is closed, and you get a wild back-and-forth ripple effect in which closing down in the U.S. can point to an 'up' day in China and vice-versa.

Below is a table of the past three days of daily returns of the largest, most-traded U.S. ETF that tracks mainland China stocks: the Deutsche X-trackers Harvest CSI 300 China A-Shares ETF (ASHR). It is a great illustration of why there is more than meets the eye.

Basically, it is all about figuring out where the floor is each day. The daily return of ASHR reflects the price of market sentiment of China during U.S. hours, minus any moves that had to be worked off—or added—from the previous night. 

If those moves aren't taken into consideration, it's easy to misread the situation. Bill Gross, lead manager of the $1.3 billion Janus Global Unconstrained Bond Fund, demonstrated this on Thursday, when he predicted during an interview on Bloomberg TV that China would open down 6 percent on Friday. He based this prediction on the U.S. ETFs tracking China. ASHR was, in fact, down 6 percent on Thursday, just as the table shows above.

His conclusion was logical but nonetheless way off. The fact that ASHR was down 6 percent for the day was actually a good sign that pointed to China shares opening in positive territory. This was because it was less than the 7 percent drop in China the night before, when the market tore downward and tripped circuit breakers.

ASHR immediately went down 7 percent to pay off the credit from China’s horrible day. This became the new floor. So if ASHR were to close down less than 7 percent, it would point to a move up in China; if it went down more than 7 percent, this would be a bad sign indicating a down market opening in China (barring outside variables).

So where did China open? Up 2 percent, not even close to the 6 percent drop Gross had predicted.

Reading ASHR can get even trickier than that, as Friday's trading showed.

ASHR was up .54 percent on the day, yet this was bad news for China’s market on Monday because it was less than the 2 percent China was up overnight, minus the 1 percent carried over from the day before. ASHR fell below its +1 percent floor because the Standard & Poor's 500-stock index was down on Friday, leading U.S. investors to believe that some of this would spill into China. This is an example of how ASHR is hit by ripples—and waves—from both U.S. and China markets. 

China did, in fact, have a bad day on Monday—but it was much worse than the .50 percent ASHR predicted, falling 4.7 percent. This goes back to the independent variable that mainland investors constitute, not to mention that a weekend provides time for further change.

So did ASHR close down 4.2 percent on Monday to catch up? No. After working off that hangover, it closed down "only" 2 percent. This was—you guessed it—good news that pointed to China opening on a positive note come Tuesday. As such, China’s market went on to open 1 percent higher on Tuesday morning.

If this seems confusing, that's because it is.

While ASHR can be a good measure of what U.S. investors think of China, nothing is what it appears at first glance, as happens so often in the People's Republic market. 

Eric Balchunas is an exchange-traded-fund analyst at Bloomberg. This piece was edited by Bloomberg News. 

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