Escott – 4th time lucky! With MSCI set to add “A” shares come Jun 2018, which ETFs to consider?

MSCI announced in late June that come June 2018, it will add 222 large-cap China A shares (Chinese companies whose stocks trade on the country’s two domestic exchanges) to the MSCI Emerging Markets and ACWI indexes. This was a long-discussed and widely anticipated decision.

 

MSCI’s Head of Research for Asia Pacific notes that China A-shares – along with frontier markets – historically have demonstrated relatively low correlations with the rest of the world, leading to potential diversification effects at the total portfolio level. Compared to the MSCI China Index, the MSCI China A Index has three times the number of total constituents. In addition, the two indexes have very different sector concentrations and combining them may provide a better representation of the long-term growth of China’s domestic economy.”

 

While inclusion of China A shares is a little under 11 months away, investors have started to look at how this change may affect their portfolios. Longer term, if China continues to liberalize the A shares market and MSCI were to fully include them, China’s weight in the MSCI Emerging Markets Index could rise markedly, to 40.8% from 28% currently.

 

Following MSCI’s announcement, BlackRock published a report outlining its view and outlook for investing in China. BlackRock believes that this announcement from MSCI is another signal that investors should review how they think about China. It believes that the current consensus view that Chinese growth will continue to falter after 16 years of +10% GDP growth is somewhat flawed as it is based on outdated perceptions.  The firm’s China experts note that in the past few years, policymakers in China have taken important steps to seek to address China’s problems, particularly since 2013. For example, the government has introduced broad supply-side reforms to curtail overbuilding and unlimited access to credit. The result has been a “virtuous feedback loop”: An improving global economy provides leeway for reforms and structural improvements, which raises economic expectations and ultimately real growth potential in China.

BlackRock notes that we have already seen increased earnings in the manufacturing sector, and overall consumer confidence is up. BlackRock notes that it is not expecting the same levels of growth of the past 15 years, a normalization to positive and sustainable growth supported by balanced policies and the unwinding of past excesses is underway. While the outlook is favourable, BlackRock also notes, importantly, Patience may be required. China’s equity markets have historically been closed and loosely regulated. This has been gradually changing, but it continues to evolve. Another positive trend that BlackRock highlights is the country’s economic realignment away from investment toward consumption has freed up corporate capital. The publicly listed companies have slowly moved away from bloated state-owned enterprises, to sectors and companies that focus on earnings and shareholder value.

 

For investors looking to add Chinese exposure to their portfolios, we consider the following four ETFs a good place to start: 

 

BMO China Equity Index ETF (ZCH)

BMO’s China ETF has been a very strong performer over the past year, delivering a return of 29.7%, outperforming many of its peers. The strong performance has continued in 2017 and YTD it has achieved a total return of 19.7%. ZCH is designed to replicate the performance of the BNY Mellon China Select ADR Index. It provides exposure to Chinese equities through ADRs (American Depository Receipts) that trade on U.S. stock exchanges. This ETF has gathered AUM of $66.7 million. There are 39 holdings in the underlying Index, with about 40% of the Index being Technology stocks, Alibaba the largest holding at close to 11%. There is also a relatively large consumer discretionary presence, at 18.4%, followed by Telecom at 12.1% and Energy at 11.5%. The remaining sectors each represent less than 5% weights. The dividend yield is modest at just 0.6% and distributions are made annually. The ETF does not hedge any of the currency exposure with investors exposed to both local currency (China) as well as the US dollar. The MER is 0.72%.

 

zch pie chart

 

iShares China Index ETF (XCH) 

iShares China focused ETF has also performed relatively well, although it has lagged the performance of ZCH. The 1-year return was 18.5% and YTD it has delivered a total return of 11.3%. This ETF is designed to replicate the performance of the FTSE China 50 Index, which it achieves by owning iShares China Large Cap ETF in the U.S., FXI. The AUM of XCH is $30.5 million with 50 holdings and the MER is 0.86%. The dividend yield over the trailing 12 months is 1.9%. The sector exposure of this ETF is quite different than ZCH, with approximately 50% of the fund exposed to Financials, 11% to Energy, 10% to Telecom and 9% to Technology. The remaining sectors represent 5% weights or less.

xch pie chart

 

Horizons China High Dividend ETF (HCN)

Horizon’s Chinese ETF is quite different again, as it seeks to achieve a high dividend yield and is designed to replicate the performance of the Hang Seng Dividend Yield Index. The constituents of the fund are net dividend yield weighted, with positions capped at a 10% weight. The dividend yield is attractive at approximately 4.0% and pays distributions quarterly. This ETF was created in January 2016, as such it does not have a very long track record. The 1-year performance has been attractive at 26.3% and YTD is 18.2%. The Hang Seng Dividend Yield Index is comprised of 50 Chinese dividend paying large and mid-cap companies that are listed in Hong Kong. The sector exposure is also very different and is weighted towards Properties & Construction at 30.0% followed by Financials at 27.6% and then Utilities at 11.3%. This ETF is quite small with AUM of $5.9 million thus far (MER: approximately 0.70%), but could garner interest in particular amongst the dividend-oriented crowd.

hcn pie chart

Vanguard FTSE Emerging Markets All Cap Index (VEE)

VEE is currently tracking the FTSE Emerging Markets All Cap China A Inclusion Index. That index is a market-cap weighted index that includes large, mid, and small-cap stocks from advanced and secondary emerging markets. Chinese equities represent approximately 29% of the Index, followed by Taiwan at approximately 16% and India at 12%. Also included in the top 10 countries is South Africa, Brazil, Mexico, Thailand, Russia, Malaysia and Indonesia.  Unlike the above noted ETFs, VEE holds over 4,000 stocks and is relatively well diversified across sectors. Financials is the largest exposure at 29.5%, followed by Technology at 13.3%, Industrials at 12.2% and Consumer Goods at 10.3%. VEE offers a reasonable dividend yield of 2.6% (paid quarterly) with a competitive MER of 0.24%. VEE is larger with AUM of $565 million, and it has also delivered strong returns over hte past year, 26.8% and 14.7% YTD. 

 vee pie chart

 

There are a variety of alternatives for investors to look at when adding exposure to Chinese markets and the differences can be quite significant, as seen in the above funds. Focusing on the ETFs with a more attractive dividend yield as well as broader diversification may help narrow it down. While we believe all of the above ETFs are worthy of consideration, we highlight VEE’s broad diversification both in countries as well as sectors, combined with the attractive dividend yield.  In a way, investing in VEE already positions investors in the post June 2018 world, in that the Index VEE follows, the FTSE EM All Cap China A Index had earlier already answered the “inclusion now, versus inclusion later question”. Importantly we note that investors opting for VEE then have to look at their Developed Markets access, in that opting for a non-Vanguard ETF on that front runs them the risk of not having any South Korean exposure (due again to index providers’ methodologies differences in terms of classification of developed vs developing).

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