Chinese ETF Flows Showing a Split Between U.S., Local Sentiment

  • U.S. traders pull $1.7 billion from China ETFs on stock slump
  • Chinese stocks have been among the worst performers this year

To see just how different the outlook for Chinese equities is between U.S. and local investors, take a look at the trend in exchange-traded fund flows.

Traders have pulled $1.7 billion from U.S.-traded ETFs focused on China’s mainland and offshore shares this year, data compiled by Bloomberg show. Similar funds available on Chinese exchanges grew by about $1.7 billion during the same period.

The divergence comes as MSCI Inc.’s decision this month not to include A shares in its global benchmark indexes gives international investors one more reason to avoid some of the world’s worst-performing stocks as China’s gross domestic product expands at the slowest pace in 25 years and bond defaults escalate. On the mainland and in Hong Kong, sentiment is more upbeat as some traders anticipate that government measures to boost growth and make the market more transparent are leading to improvements.

“Sentiment has gotten more bearish among U.S. investors on China,” Stephen Tu, senior analyst at Moody’s Investors Service, said by phone. “U.S. investors appear to be predominantly focused on the level of corporate debt combined with the slowdown in growth. These issues are also a concern of Chinese investors, but it’s balanced to a degree by a more sanguine view on the long-term, five- to 10-year growth outlook and potential positives from reform and restructuring.”

Growth Slowdown

A lack of transparency in China’s stock market contributed to a $5 trillion rout in domestic shares last year, bringing an end to the country’s longest-ever bull market. Mainland stocks have struggled to recover since then, with the Shanghai Composite posting the second-worst decline among the world’s ten biggest equity markets.

China’s gross domestic product expanded 6.9 percent in 2015, the slowest pace in a quarter century, and the median estimate of economists surveyed by Bloomberg is for 6.5 percent growth this year. The Shanghai Composite’s 18 percent year-to-date decline compares with a 0.4 percent drop in the Standard and Poor’s 500 Index in the U.S. Two out of every three China-focused ETFs on U.S. exchanges have retreated in 2016.

‘Leap of Faith’

In addition to the worsening growth outlook, foreign investors have been pulling out amid a surge in debt. Corporate and household borrowing amounted to 215 percent of GDP at the end of the first quarter, the highest level since Bloomberg Intelligence started compiling data in 2003. Billionaire investor George Soros said in April that China’s debt-fueled economy resembles the U.S. during the financial crisis of 2007-08.

“Had MSCI made a decision to include Chinese A Shares into its indexes, American investors would have set aside some of their fears about the uncertainty in the market,” David Mazza, head of ETF and mutual fund research at State Street Global Advisers in New York, said by phone. “Since this didn’t happen, investors are left focusing on the negatives U.S. investors know how important the Chinese market is, but we tend not to see U.S. investors take a leap of faith and move into Chinese stocks.”

Despite MSCI’s rejection, the sheer size of China’s market and improved access makes the it hard for U.S. investors to ignore, according to Brendan Ahern, chief investment officer at KraneShares, which oversees four China-focused ETFs.

“Some U.S. investors view the Chinese market as an enigma and remain skeptical, but as the market is becoming even more important, it’s a question of when investor sentiment will change again, not if,” Ahern said by phone.

Market Reforms

While last week’s vote in the U.K. to pull out of the European Union touched off a tumultuous two days in global markets and the price of China-focused ETFs tumbled, neither those in the U.S. or in China and Hong Kong posted big fund flows. Investors are probably still assessing the potential long-term impact of the move on global markets before deciding whether to add or withdraw money, said Mohit Bajaj, a director of ETF trading solutions at WallachBeth Capital in New York.

MSCI’s decision to not include China came despite measures the government took this year to liberalize its capital markets. In February, regulators allowed qualified traders to shift money in and out of the country on a daily basis, a key change for open-ended mutual funds and ETFs. In May, domestic stock exchanges published rules restricting trading halts. 

This month, China gave a $38 billion investment quota to the U.S., allowing U.S. institutions to invest in yuan-denominated assets in mainland markets. Beijing freed up local interest rates, vowed to give the market a bigger say in setting the yuan’s value and opened up the nation’s interbank bond market to foreigners. 

The People’s Bank of China will continue to deepen financial reform in 2016, with special emphasis on assisting with structural changes such as cutting excess capacity, the central bank’s governor Zhou Xiaochuan said in a written speech this month.

“Local investors are optimistic about an economic recovery,” said Wu Kan, a fund manager at JK Life Insurance Co. in Shanghai. “After the one-year slump, most of the market’s risks are already priced in. For overseas investors, they may have a different investment philosophy.”

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