China Small Cap ETF (HAO) Surges Ahead

by on March 29, 2010 | ETFs Mentioned:

In the wake of the most recent global economic downturn, there has been a monumental reshuffling atop the global totem pole. The emerging markets of the world have–well, emerged–as the clear leaders in a new global economy, returning to impressive growth rates as developed economies battle still-rising unemployment, deflation, fiscal crises, and a host of other economic roadblocks. China has seen its importance on the global economic stage surge, thanks to its status as one of the major trade partners of numerous countries. Developments from Beijing are now closely analyzed by investors around the globe, signaling departure from the U.S.-centric days of the past. China is now nipping at the heels of Japan for the title of the world’s second-largest economy, and most economists anticipate that it is only a matter of time before the U.S. is overtaken as well.

As interest in investing in China has increased, so to has the number of options for gaining exposure to the country. Currently, there are 17 ETFs in the China Equities ETFdb Category, including sector-specific funds, a Taiwan ETF (EWT), and Hong Kong ETF (EWH). In aggregate, these funds have nearly $15 billion in assets, with about half of that amount residing in the iShares FTSE/Xinhua China 25 Index Fund (FXI). But bigger isn’t always better, as shown by the relative performance of various China ETFs so far in 2010.

China ETF Investing - Not All Funds Are Created EqualFXI has lost about 1.6% so far in 2010, while the Claymore/AlphaShares Small Cap Index ETF (HAO) has gained about 4.6%. Although these ETFs belong to the same ETFdb Category and invest exclusively in Chinese equities, they are perhaps more different than they are alike.

FXI tracks the performance of the FTSE/Xinhua China 25 Index, a benchmark that includes the largest 25 companies in the Chinese equity market. HAO, on the other hand, is linked to the AlphaShares China Small Cap Index, a benchmark that places a $1.5 billion market cap ceiling on component stocks. As a result, there is no overlap between these ETFs, and the individual stocks held by each vary significantly in total size.

So what’s to blame for the 600 basis point difference in returns so far this year? For starters, the risk/return profiles of these funds are rather unique. Both may focus on Chinese equities, but the differences between small caps and large caps are both significant and numerous. FXI is based on China’s equivalent of the Dow Jones Industrial Average, while the index underlying HAO is more akin to S&P SmallCap 600. Just as ETFs tracking these domestic benchmarks would exhibit unique returns, so too do FXI and HAO.

Another part of the explanation lies in the sector breakdown of these two funds. The financial sector, a portion of the Chinese economy that has suffered this year, makes up about 47% of FXI’s holdings, compared to only about 13% of HAO. Consumer products have surged this year–the Global X China Consumer ETF (CHIQ) is up more than 5%–benefiting HAO more than FXI. Consumer products (staples and discretionaries) make up about 20% of HAO but only a sliver of FXI.

Not Always Better, But Different

HAO has outperformed FXI so far this year, but that obviously won’t always be the case. There will be periods of time when large caps and financials are booming and FXI will race ahead of its smaller rival. So any notion that HAO is universally superior is a misguided one. But the differences in return clearly show that these two funds are very different. For U.S. investors, exposure to Chinese equities used to be binary in nature; either you have it or you don’t. But innovation in the ETF space has significantly expanded the number of options and enhanced the granularity of exposure available (see a Guide To Small Cap International ETFs).

ETFdb Pro members can read more about China ETF options in the China Equities ETFdb Category Report (if you’re not a Pro member yet, sign up for a free trial or read more here).


Disclosure: No positions at time of writing.