April 08,2009

New Foreign Institutional Demand for China A-Shares

By Thomas Wilkins
A large internationally oriented firm in New York intends to establish an Exchange Traded Fund (ETF) whose objective will be to track the China A-Share market. Van Eck Securities Corporation of New York stated in a March 30th preliminary prospectus filed with the Securities and Exchange Commission (SEC) in Washington that it intends to submit an application with the China Securities Regulatory Commission (CSRC) for a Qualified Foreign Institutional Investor (QFII) license. The firm said that it intends to launch an ETF listed on the New York Stock Exchange (NYSE). This is believed to be the first ETF targeting the China A-Share market. 
This new ETF will compete with Morgan Stanley China A-Shares Fund, also listed on the New York Stock Exchange which has a license to trade in China A-Shares and iShares FTSE/Xinhua index fund.
The difference between the three funds is that the Van Eck fund will be passive and not actively traded. It will focus on the China A-Share market which trades in Shanghai and Shenzhen which are Yuan denominated markets. If the Chinese Yuan should gain additional appreciation versus the US dollar, both the Morgan Stanley and Van Eck funds should increase in value in dollar terms. However, the Yuan-US Dollar exchange rate has been stable for some time.
The Morgan Stanley fund is actively managed, meaning security analysts do technical and fundamental research. Portfolio managers buy and sell according to evolving evaluations. The portfolio managers for the Morgan Stanley fund are based in Singapore, whereas the Van Eck fund will most likely be managed predominately in New York. The Morgan Stanley fund was launched in September, 2006 and ran from an opening price of US$20 per share up to almost $70 per share in late 2007, only to fall back to $20 per share in late 2008 and early 2009.
Both the Morgan Stanley and Van Eck funds are subject to sell at a discount to the most recently calculated net asset value. Also, the evaluation will be subject to evaluation as there should continue to be a wide range of views about the future direction of the exchange rates and about the liquidity in the A-Share market. This is critical when A-Share funds have large positions.
Because the Chinese investors have a high propensity for turnover, the Morgan Stanley fund turn over in its first and second year of operations booked large profits and paid out large dividends. Since the Van Eck fund will not be actively managed, but passive, dividends will probably be small relative to Morgan Stanley’s fund, when and if Morgan Stanley has another robust year.
The iShares fund invests in China securities that trade in New York and Hong Kong.
The Van Eck filing with the Securities and Exchange Commission acknowledges that there are no assurances that CSRC will grant it a QFII license. The filing said the license will allow it to invest directly in the A-Share market. However, until such an application is approved, it can invest in China A-Share Access Products, swaps and derivatives which are hoped to track the China A-Share. One reading of this SEC filing is that the fund should be able to launch on the NYSE, before hearing back from its CSRC application.
The SEC application refers to the risk of investing in China. The economy migrating from a planned economy to a more market oriented economy, but its growth has been "uneven both geographically and among various sectors of the economy." If the filing is approved by the SEC, the firm will be required to highlight in a prospectus available to investors this risk as well as others listed in the SEC filing.
Many China investors were discouraged by the rapid rise and fall in the China A-Share market. For example, for the year ended December 31, 2008, the Morgan Stanley China A-Share Fund has a total return of -63.9% based on net asset value and -51.2% based on market value per share (including reinvestment of distributions, compared to its benchmark, the Morgan Stanley Capital International (MSCI) China A-Share Index which returned -61.8%. At year end 2008, the fund’s shares on the New York Stock Exchange was $20.45, almost the same as its Initial Public Offering two years earlier. The managers claim that the A-share market "is a very consensus-driven market, which has tended to overshoot on both the upside and the downside when sentiment turns."
As the Morgan Stanley fund is actively managed, the portfolio managers will switch positions to reflex their changing future outlook. At 2008 year end, the largest holding was in construction materials with $19.2 million investment in Anhui Conch Cement Co., Ltd, followed by $18 million invested in real estate with China Vanke Co., Ltd, Class A stock, followed by a $16.8 million investment in beverage maker, Kweichow Moutai Co., Ltd, Class A stock.
The Van Eck strategy will not attempt to pick stocks but will be attempt to replicate the returns in a to-be-announced China A-Shares index. A recent book on ETFs by Dr. Marvin Appel, CEO of Appel Asset Management Corporation, points out the advantages of ETFs. Normally, they avoid the expense of fund managers, they are traded on exchanges, and the creation/redemption process normally makes the ETFs market price track the market of the underlying shares. Also, these funds?performance are perceived to be more tax efficient than mutual funds. Nonetheless, these funds have specials risks, such as share price can be volatile due to any imbalances between supply and demand. In fast markets, the bid-ask spreads can be high.
Despite the downturn in the A-Share market in 2008, several reports and meetings are forthcoming and show some positive feelings based on fiscal stimulus and bank-policy easing and focuses on the macro economics of China at this time. According to the ChinaStakes April 2 article on the A-Share market, the SSE Component Index has risen by 17.31% in the first two months of 2009.
The Columbia Business School in New York is holding this week a China Business Conference with a theme of "Benchmarking China on the Global Stage." It claims that "China’s growth is reshaping the world."
Next week the CFA Institute will be holding conferences in Beijing, Shanghai and Hong Kong. The number of Asians taking this institute’s exams has grown faster than candidates from the US. This marks a dramatic reversal from a period earlier when most candidates came from Wall Street related firms. In 2008 more than 92,000 candidates worldwide took the CFA Institute’s exams, of which 8,510 came from Mainland China.
Disclaimer: This report is for informational purposes only.


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