What the Shanghai-Hong Kong Stock Connect Means for ETF Investors

by on December 9, 2014 | ETFs Mentioned:

Recent developments in China have helped to open the doors to foreign investors, prompting many to re-examine the country’s growth outlook, which is as lucrative as it is riddled with uncertainty. Recently, we had an opportunity to talk with Dodd Kittsley, head of ETF strategy at Deutsche Asset & Wealth Management, and he shared his insights on what the latest changes in China’s stock market mean for investors. 

ETF Database (ETFdb): Please provide a brief synopsis of the development taking place in China’s stock market. Why is it so important?

Shanghai, ChinaDodd Kittsley (DK): The stock markets in China are opening up to foreign investors at an increasingly rapid pace. China A-shares, the stocks listed on the Shanghai and Shenzhen exchanges, have historically only been available for purchase by mainland citizens. Limited foreign investment has been allowed through tightly regulated structures known as the qualified foreign institutional investor (QFII) and the Renminbi qualified foreign institutional investor (RQFII) systems, but the absolute size of quotas granted to institutions and asset managers has almost doubled since June 2013, bringing A-shares to an expanding set of investors.

The RQFII structure in particular has enabled investors to access the A-share market directly through exchange-traded funds (ETFs). Notably, Deutsche Asset & Wealth Management launched the United States’ first A-share ETF last November, which has seen tremendous demand from investors eager to enter this previously inaccessible market.

Another recent development is the introduction of the Shanghai-Hong Kong Connect program, which launched on November 17th. The program provides additional access to Chinese equities for foreign investors. These programs, and the speed with which they have been launched and expanded, demonstrates the Chinese government’s strong commitment to liberalizing the Chinese market, and more importantly, to globalizing the Chinese economy [see also Five ETFs that Will Live or Die By China]. 

ETFdb: What does this mean for foreign investors? How does it change the investment landscape overseas?

DK: Foreign investor access to China is something that’s evolving dramatically. The opening of the mainland Chinese equity market makes this large segment of global capital markets instantly relevant to a much broader investor base. Previously, U.S. investors were only able to participate in the Chinese equity market through share classes that are listed offshore–such as H-shares, red chips, and P chips–but the A-share market represents roughly half of the total market capitalization of Chinese equities. Foreign ownership only accounts for 1.5% of the mainland China market – that’s 1.5% of the roughly 50% of the overall market capitalization that China has to offer. Based on the pace of market liberalization we’ve seen recently, we expect this number to increase dramatically over the coming years.

Source: Deutsche Bank, International Monetary Fund, World Bank, Bank for International Settlements, CEIC Data, WIND and Haver Analytics, as of 2012, most recent data available.

Index inclusion should be another consideration for investors. MSCI is deliberating on whether to add A-shares to their widely-used MSCI EM indices. Although an inclusion has yet to occur, MSCI will review the matter next June and potentially include a slice of the A-share market. A-shares will only be included in such global benchmarks if they are easily purchasable, which incentivizes the Chinese government and regulators to make access to Chinese equities easier, broader, and more efficient.

If MSCI includes A-shares in their broader indices, meaningful inflows would likely result. In fact, over $3 trillion is indexed to the MSCI EM Index alone. If China A-shares were fully accounted for, China’s weight in the MSCI EM Index would increase from 18% to nearly 30%. Moreover, if South Korea and Taiwan graduate to developed market status, China would represent nearly half of the market capitalization of emerging market equities by today’s measures.


ETFdb: What ETFs are best positioned to take advantage of this development and why?

DK: ETFs continue to evolve and deliver innovative solutions to investors that reflect changes and advancements in global capital markets and regulations. Today, most U.S. investors interested in China execute using ETFs that offer exposure to Hong Kong-listed Chinese equities. However, offshore shares are not comprehensive and do not reflect the full opportunity set that Chinese equities offer. When we launched the Deutsche X-trackers Harvest CSI 300 China A-Shares Fund (ASHR), it was the first ETF in the U.S. to provide exposure to that part of the market [see also FXI vs. ASHR: Major Differences in These ETFs]

ASHR is an ideal complement to the existing Chinese holdings of many investors. There’s no overlap between ASHR and ETFs tracking offshore shares – ASHR holds the 300 largest, most liquid A-shares only.

Another relatively new opportunity is the Deutsche X-trackers Harvest CSI 500 China A-Shares Small Cap Fund (ASHS), which holds 500 smaller cap stocks listed in mainland China. This fund offers a unique solution for investors seeking a purer play on domestic demand in China.

For investors seeking core Chinese equity exposure, the Deutsche X-trackers Harvest MSCI All China Equity Fund (CN) is an ideal single-ticket solution. CN is based on the MSCI All China Index, which holds all Chinese stocks regardless of where they’re listed, and offers the most comprehensive and diversified exposure to Chinese stocks available today.

ETFdb: What are some potential challenges that may arise as investors flood to this new market?

DK: Probably the biggest challenge today for U.S. investors is awareness and access. Many are not familiar with the A-share market and how it differs from Chinese equities listed in Hong Kong and other listing venues offshore. Education is of paramount importance, so Deutsche Asset & Wealth Management provides a host of educational resources for investors to better understand the risks and opportunities in this new market. ASHR, ASHS and CN have paved the way access-wise, and we would expect more solutions to become available in the U.S. as the Chinese market opens further [see also Inside ASHR: A Better Way to Invest Overseas]. 

We have heard some investors voice liquidity concerns, which we think are overblown. The Shanghai and Shenzhen exchanges, where A-shares are listed, are extremely liquid and have historically had higher average daily trading volume than the DAX and NYSE Euronext exchanges in Europe.

ETFdb: What sort of impact do you expect this development to have on the underlying economy, whose growth prospects remain riddled with uncertainty?

DK: Increased access for global investors to A-share stocks will likely serve as a strong long-term catalyst for Chinese market overall. Capital flows will pick up in a meaningful way as the under-utilization of these securities by investors outside of China corrects. Overall, the actions taken in recent years by the Chinese government demonstrate strong commitment to bringing China towards market liberalization and, more importantly, globalization of the Chinese economy.

The Bottom Line

There’s no shortage of ETFs that deliver exposure to China; in fact, there’s over 20 China Equities ETFs at the moment. While there may be a wide variety of offerings to choose from, the number of products that actually target the sought after A-Shares market is far less. As such, the funds mentioned in this article and offered by Deutsche Asset & Wealth Management warrant a closer look from anyone eager to fine tune their exposure to China’s robust equity market as it continues to show signs of liberalization and growth. 

Follow me on Twitter @Sbojinov

[For more ETF analysis, make sure to sign up for our free ETF newsletter]

Disclosure: No positions at time of writing.