Inside YAO: A Whole New China ETF

by on October 20, 2009 | ETFs Mentioned:

On Monday, Lisle, Illinois-based Claymore Securities launched the Claymore/AlphaShares China All-Cap ETF (YAO). YAO is the third fund in the company’s suite of China products developed in partnership with AlphaShares, joining the Claymore/AlphaShares China Small Cap Index ETF (HAO) and the Claymore/AlphaShares China Real Estate ETF (TAO). YAO enjoyed a stellar initial session, rising about 1.2% on volume of over a million shares.

The tremendous opening day success of YAO highlights investors’ longing for additional ways to gain exposure to Chinese markets. As investors have gradually realized the importance of maintaining exposure to Chinese equities in their portfolios, the number of China ETFs, and the assets held by these funds, has grown. But not all China ETFs are created equal. When compared to the eight other funds that make the China Equities ETFdb Category, YAO distinguishes itself in a number of ways.

Beijing National StadiumAll-Cap Exposure

YAO is premised upon the belief that there are compelling investment opportunities in China beyond the largest and most liquid companies. As its name suggests, YAO establishes diversified exposure to Chinese equity markets by investing in companies of various market capitalizations. This is a sharp contrast to many of the existing China ETFs that invest in only a handful of mega-cap companies or exclusively in smaller firms.

YAO’s 99 individual holdings are spread across small, mid, and large cap companies. According to Claymore’s press release, 53% of the index underlying YAO consists of large cap equities with mid caps and small caps making up 33% and 10%, respectively.

The iShares FTSE/Xinhua 25 Index Fund (FXI), by far the most popular China ETF with more than $9 billion in assets, is dominated by holdings in mega cap companies. Claymore’s HAO, on the other hand, invests almost exclusively in small cap companies.

All-Sector Exposure

YAO’s all-cap focus has obvious benefits for investors seeking balanced exposure to China, but spreading a fund’s holdings across companies of different sizes does not necessarily provide diversified exposure to a national economy. In order to provide balanced exposure to the Chinese economy, YAO invests in every sector of the economy, including several ignored by other China ETFs.

The most obvious contrast between YAO and FXI is the allocation to consumer companies. YAO has about 10% of its holdings in the consumer staples and consumer discretionary sectors, whereas FXI has less than 1%. Some investors believe that consumer products companies have huge potential for growth in modern day China. In a country where about 15 people per 1,000 own a car (the rate is more than 750 in the U.S), and consumers account for less than half of GDP, the potential for increases in consumer spending as quality of living improves and the middle class expands are significant.

The following chart shows the breakdown of the indexes underlying YAO and FXI, as of September 30, 2009:

Sector Breakdown: YAO vs FXI

Moreover, to avoid overexposure to particular industries, the index underlying YAO imposes a maximum sector weight of 35% and a maximum allocation to any individual security of 5%. The fund also has a competitive expense ratio (70 bps) and a few other unique attributes. While A-Shares and B-Shares aren’t eligible for inclusion in the AlphaShares index, H-Shares, N-Shares, and Red Chips are, making the index more inclusive than certain benchmarks that avoid these securities. Red Chips are stocks of mainland China companies that are incorporated elsewhere and listed in Hong Kong.

The Case For China

Although the investment case for China is relatively simple, many U.S. investors have been slow to accept the need for China exposure in their portfolio. “China is the leading driver of global GDP growth today and will soon pass Japan to become the second largest economy in the world,” noted AlphaShares CIO Dr. Burton Malkiel in a press release. “However, most investors have less than 2% of their portfolio invested in China.”

While many investors remain underexposed to China, they are beginning to take note. As China’s stock market has surged ahead of the rest of the world this year, cash has been flowing into Chinese equity ETFs at a record pace. The eight ETFs in the China Equities ETFdb Category are up an average of 65% on the year, and have attracted aggregate cash inflows of more than $2.0 billion.

Between 1999 and 2008, China’s GDP increased at an annual rate of almost 15%, compared to 4% for the U.S. China is among the only regions of the world on pace to experience positive GDP growth in 2009, and is expected to set the pace for the rest of the world in 2010. Many believe that China’s GDP could surpass that of the U.S. within two decades.

Investments in China are not without risk – the potential for adverse results of government intervention is a reality. It is, after all, still an emerging market. But it is one of the largest economies in the world, and expected to be a major source of growth going forward (see more about the case for investments in China here).

With nine ETFs, including a diversified all-cap equity fund, now offering different ways to gain exposure to Chinese equities, excuses for “China-deficient” U.S. investors are running out.

Disclosure: No positions at time of writing.