Is it really a bear market for China stocks?
The unusual structure of the Chinese market means the answer depends on where you’re investing.
There was nowhere for investors who are bullish on China to hide during the country’s stock-market summer battering. Or was there?
Giant Chinese companies such as Tencent (TCEHY) and Alibaba (BABA) have posted big losses and the collapse of real estate giant Evergrande was front-page news. Shares in TAL Education have been crushed by a 94% year-to-date loss as the government has stripped its ability to make a profit in tutoring core subjects. Out of 71 US mutual funds focused on Chinese stocks that have full year-to-date records, one third are down by more than 10% and a dozen have lost more than 15% so far in 2021.
But dig under the surface and it turns out that this is only part of the story. Those numbers tend to reflect the performance of a subset of Chinese stocks that trade in the US market in the form of American depositary receipts. These stocks differ from shares trading on Chinese exchanges or even those traded in US markets that aren’t ADRs.
It may seem like a technicality, but in recent months, the type of Chinese stock being traded has at times mattered more than what its company actually does.
Here’s a look at how widely returns have varied among indexes that focus on different blends of China- and US-listed stocks. October saw a rebound in many ADRs from their worst levels, but the group as a whole is still posting heavy losses.
“While both the domestic and non-domestic 'China' markets should be inherently driven by the same fundamental factors, differences in index composition and the constituents’ listing locations result in different risk/reward profiles for investors,” says Jackie Choy, director of ETF research at Morningstar Asia.
“This is the very reason that investors should know what flavour of ‘China’ they want to achieve exposure to before investing.”
It’s important to note that China places limits on the ability of individual US investors to invest directly in stocks trading on the mainland exchanges. However, mutual fund and big institutions have a greater access to mainland listed stocks.
To better understand the faces of Chinese capital markets, two main questions need answering: What companies are offered in that particular market, and what are the risks unique to each?
What companies are offered in each market?
The Chinese capital markets can be segregated in this simple way: onshore and offshore listings. Onshore Chinese stocks are also known as China A-shares. They are the companies listed on the Shanghai or the Shenzhen bourses. Chinese ADRs belong to the offshore bucket, along with those listed in Hong Kong. In the US, there are also companies (US-Listed Non-ADRs) that become listed without using an ADR structure.
Here’s a look at the performance of the 100 largest names in each group.
The performance profile of Chinese ADRs resembles that of the companies listed in Hong Kong for a good reason: overlapping names between the two markets. There are 70 names in common. The only differences in the top 30 are e-commerce platform Pinduoduo (PDD) and electric vehicle startup NIO (NIO), which are unique to ADR investors, while China Mobile, China Telecom, and CNOOC - each of which were delisted as ADRs - and Nongfu Spring are unique to the Hong Kong market.
Another issue is company size. Hong Kong, China A-Shares and ADRs show a skewed trend toward a handful of behemoths: Tencent (HK, ADR; US$568 billion); Alibaba Group (HK, ADR; US$396 billion); and Industrial And Commercial Bank Of China (HK, China A; US$242 billion).
By market capitaliation, US-listed non-ADRs--Chinese companies registered and listed in the US - also lean toward one big name, YUM China (US$24 billion), but the 99 names that follow the fast-food operator ranged between US$1.6 billion and US$26 million in market cap terms, showing the smallest total cap among four different listings. That means the most representative Chinese US-listed non-ADRs (by scale) dip into the small, even micro-cap, territory.
A third element is sector distribution of the stocks. When it comes to stock investing, shorter-term returns, business area focuses can often be a major driver of stock returns. That was especially the case for Chinese stocks this year, when the government cracked down on Internet companies.
Firms like Tencent and Alibaba suffered in the multiple episodes of regulatory crackdowns. Communication services, the sector Tencent belongs to, fell 3.84% or 3.31% in the ADR and Hong Kong markets, respectively.
In the year-to-date period ended October, the communication services and consumer cyclical sectors retreated. And that explained the poor returns of most (not all) of the major China equity indexes.
S&P/BNY Mellon China Select ADR posted the worst performance of the four. Nearly half of the index weight bets on consumer cyclicals, like Alibaba, JD.com (JD), and Pinduoduo, which lost 29.0% between January and October 2021. “Old economy” companies belonging to the basic materials, energy, and utilities sectors have too small of a representation in the index. The strong rebound in these sectors was not significant enough to revert the losses in communication services and consumer cyclicals.
While none of these major indexes returned positively, CSI 300 Index beat the rest. Its smallest relative exposure to consumer cyclicals was one of the reasons. Even though roughly 10% of the index goes to this sector, the beaten-down names, such as Alibaba, have no direct effects--not counting a drag from the ailing sentiments in the broader China equity market--on this index and relevant trackers as there are no such companies listed on the A-Shares exchanges.
CSI 300’s return detraction came from its heaviest bets in consumer defensive and financial services. At the same time, in line with the outperformance of the “old economy” stocks, the A-shares index was greatly helped by the 7% exposure in basic materials and the 11% in industrials.
Between the ADR and the Hong Kong-listed (Hang Seng China Enterprises) indexes, the major difference that helps explain the performances remains the weight in consumer cyclicals. Additionally, banks and financials account for almost one third of assets in the Hong Kong index. Although lenders from China did not do well either, down 9% for the year to date, they buffer the benchmark from a complete meltdown in the tech and e-commerce space.
What risks are unique to each market?
Investing in foreign stocks, whether through a mutual fund or directly, entails different risks than investing in US companies, mainly fluctuations in the value of foreign currencies against the US dollar, different accounting standards, or the potential for shortcomings in company disclosures abroad. ADRs are often seen as an efficient way for US investors to put money to work with non-US companies.
However, political tensions between the US and China have raised the risk that some ADRs would be forced to delist from the US market, a key reason many China ADRs have seen prices drop sharply.
In January 2021, the New York Stock Exchange delisted China’s three largest telecom carriers. It was enforced by a U.S. government order that bars Americans from investing in companies that it says are connected to the Chinese military.
Another issue revolves around auditors. US-listed foreign companies need to be audited by a U.S.-approved auditor. The Public Company Accounting Oversight Board has been voicing a lack of access in China and it turned more vocal after the fraud of Luckin Coffee (LKNCY). The largest coffee chain in China was found to be fabricating its sales records; this was a wake-up call for regulators to tighten oversight for noncompliant companies. The US Senate recently passed a bill that would allow the SEC to suspend companies from trading if they do not comply with audit rules for two straight years instead of three.
Other than delisting risks, like other ADRs, less-popular Chinese equity names trade in a thinner volume (especially when compared with their dual-listed counterparts). When there is less liquidity in a stock, it makes a stock more prone to wide price swings and investors may see returns when buying or selling compared with a more actively traded name.
There are also risks for stocks traded in the Hong Kong or mainland China markets. There is the usual currency risk for international investing of swings in the value of the renminbi against the US dollar. (The Hong Kong dollar is pegged to the US dollar, so direct currency risks aren’t an issue there.)
But China’s limits on trading by non-Chinese investors create their own risks. Non-U.S. individual investors can only buy and sell mainland-listed stocks through the Hong Kong exchange. When there’s a public holiday in Hong Kong--which can differ from those of the mainland--trading in A-Shares will be closed for those days. That means investors have to sit on those positions and wait for the Hong Kong market to reopen to adjust their investments.
Know what you own
When brought all together, these factors mean mutual fund investors need to check carefully under the hood to understand the nuances of a fund’s strategy.
While these funds may initially appear similar, they can take radically different approaches in how they invest in Chinese companies. Some funds invest exclusively in China A shares or HK-listed securities, while others primarily own American depositary shares. Where and how the fund invests also affects the type of companies available to the fund--funds invested in only A-Shares may be tilted toward more "old economy" sectors like financial services and energy, while funds investing in companies listed on the Hong Kong exchange or as ADRs are more exposed to the communication services and consumer cyclical sectors.
Here’s a look at five funds, their performance, and weightings to stocks with different listings.
Complicating matters, though funds often own the same company--for example, Alibaba is a top holding in most China funds--some funds own the company on the Hong Kong exchange while others own the ADR listed on the New York Stock Exchange.
Few funds invest primarily in China A Shares, including Xtrackers Harvest CSI 300 China A ETF (ASHR) and iShares MSCI China A ETF (CNYA).
Xtrackers Harvest CSI 300 China A ETF tracks the 300 largest names listed on the Shenzhen and Shanghai exchanges. As mentioned above, there are no communication services companies listed on either, leading the fund to a slightly different makeup than a fund that owns Hong Kong listed or ADR fund. Its top holdings include Kweichow Moutai, a liquor producer (a 5.78% weight), and China Merchants Bank (3.16%).
MSCI China A ETF invests more broadly, holding 484 companies in total that are listed on either the Shanghai or Shenzhen Stock exchanges.
Among the four largest Chinese equity ETFs listed in the US, iShares MSCI China ETF (MCHI) has the widest investment scope, covering all Chinese enterprises regardless of their listing destinations. According to Morningstar Direct, the tracker invests in 614 companies, more than half of them listed in Shanghai or Shenzhen.
Instead of investing in China A shares, iShares China Large-Cap ETF (FXI) invests in the 50 largest companies listed on the Hong Kong exchange. The fund's largest holdings include Meituan, Alibaba, and Tencent.
IShares MSCI China ETF holds a blend. Fifty-seven percent of its portfolio is in China A shares, 34% in Hong Kong listed securities, and another 5% in ADRs. The fund holds similar names to the iShares China Large-Cap ETF. Both funds own JD.com and Baidu (BIDU), but iShares MSCI China owns the ADR while iShares China Large-Cap ETF owns the companies on the Hong Kong exchange.
The most popular China fund this year, Krane Shares CSI China Internet, primarily owns ADRs. Sixty-three percent of the fund is in ADRs and remaining portion of the fund is invested in Hong Kong listed securities. The fund focuses on the largest Chinese Internet companies that are often available as ADRs. Some of the fund's largest holdings include Alibaba, JD.com, Tri.com, and Baidu, that are all available as ADRs. The fund has been hit hard this year, falling 35% since January 1.