Insight

Accessing China’s equity market

Accessing China’s equity market
Key takeaways
1

Beijing is committed to transforming a country once known almost exclusively for manufacturing cheap goods into a global leader in technology.

2

Characteristics specific to the Chinese equity market have enabled some synthetically replicated China ETFs to gain an advantage over their physical counterparts.

3

China is likely to continue opening its capital markets to attract foreign investors, although efforts by Beijing may increase competition for swaps.

We’ve all heard the stories of China’s enormous growth potential, with its economy forecast to leapfrog the US and take top spot by around 20351. China’s GDP growth is predicted to be more than 5% this year, as the country’s reopening following abandoning its Covid zero policy spurs domestic growth. 

Despite being largely closed to the outside world until a couple decades ago, China also has the second-biggest equity market. Here’s how ETF investors can gain broad China exposure and why synthetic replication can be a potential performance advantage.
 

Simplifying China’s equity markets

Gaining exposure to China’s financial markets was once quite difficult for foreign investors. The only way most people could invest in Chinese equities was through Hong Kong-listed H-shares (for companies incorporated in Mainland China) or to invest in companies incorporated and listed outside of China (Red-Chips in Hong Kong, S-Chips in Singapore, or N-Shares in the US).

It wasn’t until Beijing’s introduction of the Qualified Foreign Institutional Investor (QFII) scheme in 2002 and, perhaps even more significantly, the Stock Connect programme in 2014 that foreign investors could access China’s genuine domestic market. A-Shares have been arguably the most relevant part of the country’s equity market, as they are issued by companies incorporated on the mainland and traded in Renminbi on either the Shanghai or Shenzhen stock exchange. These tend to offer more direct exposure to China’s domestic growth opportunities.
 

Gaining broad exposure to China

Beijing is committed to transforming a country once known almost exclusively for manufacturing cheap goods into a global leader in technology. The government’s ambition is to drive innovation in areas ranging from artificial intelligence to clean energy, with the latter being particularly crucial given the major task ahead to replace the country’s predominantly coal-powered electricity with wind, solar and other renewable technologies.  

Not only are Chinese companies involved in technological advancement, but almost 70% of the China A-Shares market cap is positively linked to China’s “Common Prosperity” policy. The term has been used by previous leaders, but the concept was redefined by Xi Jinping in 2021. It is now meant to symbolise increased social and economic equality, involving raising the income of the lowest earners while regulating the highest earners so that the wealthy are encouraged to “give back” to society. The policy should create opportunities in education, health care and retail sectors.

ETF investors wanting exposure to all these growth opportunities have a choice of indices. The broadest exposure would include the entire Chinese equity universe of domestic A-Shares as well as those Chinese companies listed in either Hong Kong, Singapore or the US. Some investors may choose instead to focus on the A-Shares market either in its entirety or a specific segment. For example, the S&P China A 300 index is comprised of the largest 300 companies on the Shanghai and Shenzhen exchanges, while the S&P China A MidCap 500 index comprises the next 500 largest.  

For some indices, ETF investors can select between physical and synthetic replication methods.
 

Potential advantages of synthetic exposure

Characteristics specific to the Chinese equity market have enabled some synthetically replicated China ETFs to gain an advantage over their physical counterparts. The most notable example is where an ETF is tracking one of the China A-Shares indices.

The role played by retail investors. In China, retail investors are much more involved in equity trading than is seen in most countries, both in absolute terms and as a percentage of the overall market activity. Institutional investors play second fiddle, due partly to limits placed on foreign investors by Beijing, but also because China is significantly under-represented in emerging market indices (and therefore in investor portfolios). Many of China’s retail investors are actively buying and selling individual stocks on momentum, often resulting in overbought and oversold valuations. This presents hedge funds with an attractive market environment for long-short equity strategies.

Normal hedging facilities are limited. Securities lending and onshore swap derivative markets have been out of the reach of most foreign investors, and what facilities are available on China A-Shares have been limited only to domestic brokers. Hedge funds need another way to offset their market positions. In a nutshell:  the hedge fund wants to make a profitable trade and pays some of the potential profit (via a fee) to an investment bank to hedge the market exposure. The investment bank needs to hold an inventory of stocks that it can sell in order to offset this market exposure … and this is where the synthetic ETF comes in.

Synthetic ETF is the biggest buyer in town. An ETF that replicates an index synthetically does so using swaps. It holds a basket of securities (different from those in the index) and uses swaps to provide it with the index return. On the other side of these swaps is an investment bank (or banks) that will buy the underlying securities of the index to hedge their exposure to the ETF. It is this inventory of stocks that allows a bank to enter into the contract with the hedge funds and, as a result, investment banks are often willing to pay the ETF a fee2 for the swap. This is highly unusual, because on most other indices it would be the ETF that pays the fee.

The result? In this example, the ETF would receive the index return plus the swap fee from the investment bank (the swap counterparty). In other words, a synthetic ETF has the potential to outperform the index under certain circumstances, although these circumstances may not persist indefinitely. It’s also worth noting that the magnitude of the advantage due to the receipt of a swap fee may vary over time. Since March 2018, the average outperformance due to the swap fee has been 3.0% on the large-cap S&P China A 300 index and 6.3% on the S&P China A MidCap 500 index3. Past performance should not be relied upon for the prediction of future returns.
 

Conclusion and caveats - the potential risks and benefits of investing in China?

We believe the outlook for China is favourable given the predicted growth versus the developed world but acknowledge there will be risks involved. For investors wanting exposure to China, we offer a physical ETF that aims to track the broadest universe of Chinese equities and two synthetic ETFs that aim to track large-cap and mid-cap segments of the China A-Shares market.

China is likely to continue opening its capital markets to attract foreign investors. Further efforts by Beijing should have positive overall effects, such as increasing liquidity, improving efficiency and reducing costs. On a more cautionary note, these efforts may increase competition for swaps. While that scenario may reduce the performance advantage currently enjoyed by synthetic ETFs, investors would still have the efficient index tracking that’s the real hallmark of these products.

Gaining exposure to China’s financial markets was once quite difficult for foreign investors. The only way most people could invest in Chinese equities was through Hong Kong-listed H-shares (for companies incorporated in Mainland China) or to invest in companies incorporated and listed outside of China (Red-Chips in Hong Kong, S-Chips in Singapore, or N-Shares in the US).

 

It wasn’t until Beijing’s introduction of the Qualified Foreign Institutional Investor (QFII) scheme in 2002 and, perhaps even more significantly, the Stock Connect programme in 2014 that foreign investors could access China’s genuine domestic market. A-Shares have been arguably the most relevant part of the country’s equity market, as they are issued by companies incorporated on the mainland and traded in Renminbi on either the Shanghai or Shenzhen stock exchange. These tend to offer more direct exposure to China’s domestic growth opportunities.

 

Gaining broad exposure to China

 

Beijing is committed to transforming a country once known almost exclusively for manufacturing cheap goods into a global leader in technology. The government’s ambition is to drive innovation in areas ranging from artificial intelligence to clean energy, with the latter being particularly crucial given the major task ahead to replace the country’s predominantly coal-powered electricity with wind, solar and other renewable technologies.  

 

Not only are Chinese companies involved in technological advancement, but almost 70% of the China A-Shares market cap is positively linked to China’s “Common Prosperity” policy. The term has been used by previous leaders, but the concept was redefined by Xi Jinping in 2021. It is now meant to symbolise increased social and economic equality, involving raising the income of the lowest earners while regulating the highest earners so that the wealthy are encouraged to “give back” to society. The policy should create opportunities in education, health care and retail sectors.

 

ETF investors wanting exposure to all these growth opportunities have a choice of indices. The broadest exposure would include the entire Chinese equity universe of domestic A-Shares as well as those Chinese companies listed in either Hong Kong, Singapore or the US. Some investors may choose instead to focus on the A-Shares market either in its entirety or a specific segment. For example, the S&P China A 300 index is comprised of the largest 300 companies on the Shanghai and Shenzhen exchanges, while the S&P China A MidCap 500 index comprises the next 500 largest.  

 

For some indices, ETF investors can select between physical and synthetic replication methods.

 

Potential advantages of synthetic exposure

 

Characteristics specific to the Chinese equity market have enabled some synthetically replicated China ETFs to gain an advantage over their physical counterparts. The most notable example is where an ETF is tracking one of the China A-Shares indices.

 

The role played by retail investors. In China, retail investors are much more involved in equity trading than is seen in most countries, both in absolute terms and as a percentage of the overall market activity. Institutional investors play second fiddle, due partly to limits placed on foreign investors by Beijing, but also because China is significantly under-represented in emerging market indices (and therefore in investor portfolios). Many of China’s retail investors are actively buying and selling individual stocks on momentum, often resulting in overbought and oversold valuations. This presents hedge funds with an attractive market environment for long-short equity strategies.

 

Normal hedging facilities are limited. Securities lending and onshore swap derivative markets have been out of the reach of most foreign investors, and what facilities are available on China A-Shares have been limited only to domestic brokers. Hedge funds need another way to offset their market positions. In a nutshell:  the hedge fund wants to make a profitable trade and pays some of the potential profit (via a fee) to an investment bank to hedge the market exposure. The investment bank needs to hold an inventory of stocks that it can sell in order to offset this market exposure … and this is where the synthetic ETF comes in.

 

Synthetic ETF is the biggest buyer in town. An ETF that replicates an index synthetically does so using swaps. It holds a basket of securities (different from those in the index) and uses swaps to provide it with the index return. On the other side of these swaps is an investment bank (or banks) that will buy the underlying securities of the index to hedge their exposure to the ETF. It is this inventory of stocks that allows a bank to enter into the contract with the hedge funds and, as a result, investment banks are often willing to pay the ETF a fee[1] for the swap. This is highly unusual, because on most other indices it would be the ETF that pays the fee.

 

The result? In this example, the ETF would receive the index return plus the swap fee from the investment bank (the swap counterparty). In other words, a synthetic ETF has the potential to outperform the index under certain circumstances, although these circumstances may not persist indefinitely. It’s also worth noting that the magnitude of the advantage due to the receipt of a swap fee may vary over time. Since March 2018, the average outperformance due to the swap fee has been 3.0% on the large-cap S&P China A 300 index and 6.3% on the S&P China A MidCap 500 index[2]. Past performance should not be relied upon for the prediction of future returns.

 

Conclusion and caveats - the potential risks and benefits of investing in China?

 

We believe the outlook for China is favourable given the predicted growth versus the developed world but acknowledge there will be risks involved. For investors wanting exposure to China, we offer a physical ETF that aims to track the broadest universe of Chinese equities and two synthetic ETFs that aim to track large-cap and mid-cap segments of the China A-Shares market.

 

China is likely to continue opening its capital markets to attract foreign investors. Further efforts by Beijing should have positive overall effects, such as increasing liquidity, improving efficiency and reducing costs. On a more cautionary note, these efforts may increase competition for swaps. While that scenario may reduce the performance advantage currently enjoyed by synthetic ETFs, investors would still have the efficient index tracking that’s the real hallmark of these products.


[1] Technically, the fee is still payable by the ETF but in this case it “pays” a negative fee.

[2] Source: Invesco, Goldman Sachs, Bloomberg, as at 8 February 2023. Past performance is not a reliable indicator of future returns. 

Related insights

Footnotes

  • 1

     Source: Goldman Sachs, December 2022

  • 2

    Technically, the fee is still payable by the ETF but in this case it “pays” a negative fee.

  • 3

    Source: Invesco, Goldman Sachs, Bloomberg, as at 8 February 2023. Past performance is not a reliable indicator of future returns.

Investment risks

  • The value of investments, and any income from them, will fluctuate. This may partly be the result of changes in exchange rates. Investors may not get back the full amount invested.

    The ETFs invest in emerging and developing markets, where there is potential for a decrease in market liquidity, which may mean that it is not easy to buy or sell securities. There may also be difficulties in dealing and settlement, and custody problems could arise.

Important information

  • Data as at 31 March 2023, unless otherwise stated. This is marketing material and not financial advice. It is not intended as a recommendation to buy or sell any particular asset class, security or strategy. Regulatory requirements that require impartiality of investment/investment strategy recommendations are therefore not applicable nor are any prohibitions to trade before publication.

    Views and opinions are based on current market conditions and are subject to change. UCITS ETF’s units / shares purchased on the secondary market cannot usually be sold directly back to UCITS ETF. Investors must buy and sell units / shares on a secondary market with the assistance of an intermediary (e.g. a stockbroker) and may incur fees for doing so. In addition, investors may pay more than the current net asset value when buying units / shares and may receive less than the current net asset value when selling them. For the full objectives and investment policy please consult the current prospectus.